The darker side of benchmark linked-investments

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48243344 - stock market graphs, business chart /123RF Stock PhotosWhile investing in products underpinned by a benchmark can offer opportunities for investors, these products and their benchmarks are not without problems, according to research from the Healthy Markets Association.

For example, the benchmarks used in these products may be subject to conflicts of interest, at risk of being manipulated and not be transparent enough, the study said.

“Conflicts of interest could manifest themselves with administrators trading for their own benefit around changes to the components or calculations of the benchmark, making benchmark changes for their own benefit or to benefit preferred clients, manipulating the benchmark pricing to artificially inflate a product’s performance, or overstating the benchmark’s tracking ability,” noted the research.

If those submitting inputs for benchmark calculation are also those with stakes in the level of that benchmark, for example, there may be incentives to manipulate the determination process, according to the International Organization of Securities Commissions, as referenced in the report.

In addition, if there are not sufficient policies in place dictating what it is appropriate for a submitter to do, it’s harder to for stakeholders to accurately evaluate the credibility of a benchmark, the IOSCO noted.

The study also emphasized that these concerns are real, noting that since 2012, over a dozen banks and brokers have settled cases for this type of manipulation, impacting hundreds of trillions of dollars of benchmark-linked investment products.

As well, in some cases, benchmarks were found to no longer truly represent the exposures they were touted to capture, the study said.

Investors and regulators should address four key lessons: it’s important to give careful scrutiny to the integrity of data underlying benchmark-linked investment products, to understand who establishes and administers a benchmark and what criteria they use, to ensure the data is sufficient and current with changing realities and to ensure that the benchmark inputs and calculation methodologies are transparent and accountable, the study added.

“Investors should understand how the benchmarks to which their investments are linked operate, and how the risks and conflicts of interest in benchmark creation and administration will impact them,” the study recommended. “At the same time, regulators should work collaboratively to reduce risks and conflicts of interest by implementing a regulatory framework that establishes clear standards for benchmark governance, quality, methodology, and accountability.”

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