EC Legislation to Regulate Financial Indexes

EC Legislation to Regulate Financial Indexes

EC Legislation to Regulate Financial Indexes

by Philippe Zaouati and Carlos Joly

Philippe Zaouati (French, born 1966) began his career in 1990 as analyst at Dresdner Group in Paris. He is supervising MIROVA, the newly created entity of Natixis dedicated to Responsible Investments. He is also chairing the Responsible Investment Working Group of the European Asset Managers Association (EFAMA). Philippe has written several books, including Responsible Investing: in search of new values to finance.

Carlos Joly (Argentinian, born 1947) has lived and worked in Europe for twenty-five years. He is an investment manager who over the years has pioneered various approaches to integrating environmental issues in portfolio management. He is currently chair of the Climate Change Scientific Avisory Committee of Natixis Asset Management in France.

This note concerns the draft legislation proposed by the European Commission to help restore confidence in the integrity of financial benchmarks[1]. The European Commission wishes to extend its regulatory reach beyond LIBOR-setting to ‘benchmarks that measure the performance of an investment fund’. The ultimate objective is to ensure the integrity of benchmarks by guaranteeing that they are not subject to conflicts of interest, that they reflect the economic reality they are intended to measure and are used appropriately’ (emphasis added).

Four critical and important points concerning stock and bond market, and soft commodity benchmark indexes, should be brought to the European Commission’s attention:

The most widely used benchmarks for equity and bond funds do not measure the economic reality they are intended to measure. Equity benchmarks generally reflect the relative size of the capital of companies as valued by the stock market, not their real economic value, and particularly when environmental and social externalities are taken into account. The stock markets are often notoriously wrong in pricing the real economic value of companies, as they establish prices that are either too high or too low in economic terms. Bond indexes may also be subject to the same errors, particularly sovereign bond indexes that reflect sovereign bond prices that may have little to do with political and economic fundamentals.

The prevalence of passive investment strategies in institutional investment (i.e. investment funds that seek to replicate the performance of a given stock or bond index or that are managed to a narrow tracking error relative to such an index) has the effect of exacerbating mispricing. Passive and near-passive strategies mean that the prices of underlying instruments (stocks or bonds) are automatically inflated or deflated according to how much money is placed to follow an index, further distancing the prices of the underlying instruments and the indexes from economic reality. This systematic fault can lead to systemic failure, creating bubbles and crashes in the stock and bond markets that have a negative effect on the economy.

As regards the EU’s desire to promote long-term investment, and particularly long-term investment that supports the transition to a low carbon and greener economy, the most widely used stock market benchmarks are biased in favour of the past, in favour of companies that owe their success to economic and regulatory conditions that are unhelpful in the new economic context. Stock market capitalization is a poor criterion for future economic success and a particularly poor criterion for sustainable economic, environmental and social success. However, the way indexes are currently constructed, combined with the pernicious effect of passive and near-passive investment, acts as a barrier to the progress of sustainable development. Capital is channelled disproportionately into old-economy companies rather than green economy companies, and companies that may wish to move strategically in line with sustainable development find little incentive from stock and bond markets to do so.

Benchmarks should appropriately measure and stimulate the transition to a low carbon economy by tilting capital towards the most responsible, innovative and efficient companies, better reflecting the moving economic present as opposed to reflecting – and through the transmission effect of passive investment strategies, exacerbating – the economically negative effects of valuation methods anchored in of the past.

Financial benchmark indexes for soft commodities (i.e. agricultural products) arguably promote financial behaviours that increase food prices and volatility. Ways can be found to limit the inappropriate financial use of such benchmarks, and for developing benchmarks that are more responsive to sustainable food production.

In sum, the most commonly used stock and bond market benchmark indexes cause economic harm, distort pricing information, and cause financial behaviours that are inimical with the EU’s aspirations for a competitive low carbon economy. In short they constitute a barrier to the EU’s economic, environmental and social welfare goals.

As the European Commission moves to regulate financial benchmarks, the responsible investment community will encourage it to consider the construction and wide adoption of stock and bond market benchmark indexes that are properly aligned with the low carbon and social goals to which the EU is committed.

As a partial and swift solution to this challenge, the Cambridge Investment Leaders Group could potentially offer its expertise to the European Commission in the possible development of guidelines for stock and bond market benchmarks that are more responsive to today’s economic reality, and particularly to the reality of transitioning to a low carbon and more efficient economy.

If such guidelines are formulated and adopted, the ILG could make itself available for consultations with index providers for the construction of such indexes.

As leading investment institutions with significant market power, members of the ILG could potentially pilot test such indexes in their investment practice, and research their effects on investment risk, returns and impact on sustainable development.

[1] Press Release of 18.09.2013; Proposal for a Regulation of the European Parliament and of the Council on indices used as benchmarks in financial instruments and financial contracts; Commission Staff Working Document Impact Assessment; and speech by Michel Barnier, De nouvelles mesures pour restaurer la confiance dans les indices de référence, à la suite des scandales du Libor et de l’Euribor.

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