The absence of simple disclosure in a licensing agreement about an Auto Hold feature for a volatility index managed by S&P Dow Jones Indices (S&P DJI) prompted the U.S. Securities and Exchange Commission (SEC) to take action, further establishing a framework for index providers.
On May 17, 2021, the S&P DJI agreed to pay $9 million to settle an SEC enforcement action that should be a topic of discussion at your firm’s next compliance and risk management meetings. The fine resulted from S&P DJI’s failure to update its S&P 500 VIX Short-Term Futures Index ER every 15 seconds as required between 4:09 and 5:09 p.m. on February 5, 2018. During that one-hour period, the index in question was not updated at all, even as the underlying CBOE Volatility Index (VIX) was spiking 115% higher. You can learn more about this from the SEC Press Release, SEC Order, and SEC Public Statement.
A Costly Glitch
The turmoil resulted when an Auto Hold mechanism for the index was triggered on a day of wild trading and extreme market volatility known as “Volmageddon”. But the markets were not aware of the S&P DJI’s Auto Hold feature because it was not publicly disclosed in any index licensing agreement and not overridden that day by S&P DJI personnel. The SEC levied the $9 million fine against S&P DJI for briefly publishing “stale” prices for an index that underpinned a popular volatility-linked fund known as XIV when it imploded.
Sadly, all of this could have been avoided had proper disclosures been made and standard operating procedures implemented at the outset.
It’s important to note that the SEC said the lack of disclosure on the Auto Hold trigger was exacerbated by the fact that one of the two index managers responsible for updating the index in question that day was out of the office. That left only one person to monitor “thousands of indices” and created the need for S&P DJI to update its policies and procedures for its index managers.
A Domino Effect
S&P DJI’s failure to update its index has prompted investors to file a lawsuit alleging fraud against Credit Suisse, whose ability to price its VelocityShares Daily Inverse VIX Short-Term Exchange-Traded Notes (XIV Notes), was dependent on the S&P DJI index. The SEC said the stale data contributed to a catastrophic 96% drop in the value of XIV Notes and an estimated $1.8 billion in losses for investors, who allege that Credit Suisse tried to collapse that market by shorting VIX futures and hedging XIV Notes to profit at their expense.
“When index providers license their indices for the issuance of securities, as S&P DJI did here, they must ensure that the disclosure of critical features of their products, as well as the publication of real-time values, are accurate,” said Daniel Michael, chief of the SEC enforcement division’s complex financial instruments unit.
Prominent disclosures within the License Agreement and elsewhere could have put the markets on notice and potentially could have prevented these headaches. Fallout from this event is likely to continue as index providers are being more heavily scrutinized by regulatory authorities. Five years ago, the European Securities and Markets Authority (ESMA) was given regulatory responsibility over index and benchmark firms in the European Union. Such firms are not regulated in the U.S. because indices are not considered securities. They are viewed as objective and mathematical reflections of markets. But it is speculated that could now change.
The exponential growth of ETFs has helped the three largest index firms – S&P DJI, MSCI, and FTSE Russell – take a combined 70% market share. Overall, passive investment funds have $15 trillion in assets under management. The index industry’s rise to prominence has increased speculation the SEC might shelve the “publisher’s exclusion” that shields index providers from being classified as investment advisers under the ’40 Act.
The pricing snafu at S&P DJI can be attributed to human error. The mid-level manager on duty the day of Volmageddon should have been able to follow existing policies and procedures and continue pricing the index. Disclosures related to the Auto Hold future also should have been prominently made.
Money managers often enter into licensing agreements with various companies to create custom indices. If you haven’t yet done so, now’s the time to perform due diligence on your index providers and ask whether there are any features, such as an Auto Hold trigger, that they have not disclosed that would affect pricing.
Indexers, meanwhile, should review their policies and procedures to determine whether any manual functionalities have been omitted that should be included. Jacko Law Group can work with your team to help perform due diligence, ask the right questions, and make certain necessary disclosures are made to protect your firm and investors. Give us a call today at (619) 298-2880 or visit us at jackolg.com for more information.