European Indexers' Business Model: Under Pressure?

by: IndexUniverse Europe

By Paul Amery

Index providers have benefited handsomely from the growth of the worldwide ETF business and the general trend towards passive, index-based investing. But, just as ETF fees are under pressure from the increasing competition provided by new market entrants, so too are index providers’ traditional licensing fee models, which may have to be rewritten after a recent ruling by the German Federal Supreme Court.

The court ruling relates to an ongoing dispute between Commerzbank and the German Stock Exchange, Deutsche Boerse, over licensing fees. Earlier this decade Commerzbank issued index certificates (a type of warrant) based on the DAX (the benchmark German equity index) but then argued that it did not need to pay fees to Deutsche Boerse, the compiler and owner of the index, to do so. Deutsche Boerse, on the other hand, maintains that Commerzbank’s use of the DAX name in its index certificates constitutes an unfair use of the exchange’s trademark rights.

While an initial judgement in the Frankfurt regional court in 2005 prohibited Commerzbank from using the DAX name on its certificates on the grounds of unfair competition, subsequent rulings by the Frankfurt Higher Regional Court in 2007 and the Federal Supreme Court in April this year reversed this stance and found in favour of the bank.

A spokesman for the Deutsche Boerse told IndexUniverse.eu that the exchange is awaiting the full written judgement by the Supreme Court (due in the autumn) before making any comment on the ruling. Commerzbank also declined to comment.

Potential Repercussions

The court ruling, if applied to other index-tracking products such as ETFs, could have major repercussions. While the precise licence fee models used by index providers in the ETF market are generally not disclosed, a senior industry source told IndexUniverse.eu that a fee of 5-10 basis points for licensing an index to an ETF provider is typical. If expressed as a percentage of the fund’s total expense ratio, the fee usually falls in the 12-25% range.

Given that the weighted average total expense ratio on a European ETF is around 30 basis points, according to Barclays Global Investors, these ranges are broadly equivalent, he said. He added that licensing deals at the upper end of these scales might grant exclusive use of a particular index to an ETF provider, something that was quite common in the early days of the ETF market but less so now that there are many more issuers involved.

If applied to the US$166 billion that Barclays Global Investors calculates was invested in European ETFs at the end of the June quarter, this implies an annual revenue stream of US$83-166 million for index providers—and that is only from European exchange-traded funds. According to BGI, global ETF assets now total US$789 billion, so a similar fee scale could imply revenues in excess of half a billion dollars a year for the index licensors.

In practice, index fees on the largest US ETFs appear to be slightly below the quoted range. In an article published last summer in Intellectual Property Litigation, New York-based lawyer Jonathan Mazer points out that the SPDR, the largest US equity ETF, disclosed in its 2007 accounts that it pays 3.5 basis points a year to Standard & Poor’s for use of its S&P 500 index. Nevertheless, it is clear that hundreds of millions of dollars in revenues are at stake for index providers.

But could Commerzbank’s argument that licensing fees are not appropriate for a particular type of index derivative be applied more broadly across Europe, and could it also affect other index-tracking products, such as ETFs?

Two index providers told IndexUniverse.eu on condition of anonymity that they are so far interpreting the German Federal Supreme Court’s judgement narrowly; in other words, that it would not necessarily have implications beyond the country’s borders or for other types of indexed financial instruments.

However, Dr. Henning Harte-Bavendamm, an intellectual property lawyer who acted on behalf of Commerzbank in the dispute over the use of the DAX index name, said that, while the court’s judgement is formally restricted to Germany, European trademark law should be uniform across the region and courts in other EU countries could be expected to arrive at the same result. He believes that the German Federal Supreme Court’s judgement should therefore have an impact on how the law is interpreted in other EU member states.

As far as the implications for other types of index-based investment instruments are concerned, in the May 2009 edition of its Intellectual Property News publication, law firm Linklaters points out that if the index name is used only descriptively, or as a “reference” for the financial product, then no licensing fees should be charged. However, if the index name is incorporated into the product’s actual title then a license from the index provider is required, Linklaters argues.

This distinction appears to have direct parallels to a 2004 index-related lawsuit in the US. In a November/December 2006 article in the Journal of Indexes by Jonathan Mazer and Alison Rende (“Going…going…gone…?”), the authors discuss a case brought by the Nasdaq Stock Market against the Arca Exchange for trading in the QQQ (Nasdaq-100 Trust Series 1 ETF) without a license. A US federal court dismissed the claim, reasoning that Nasdaq did not have any protectable interest in the QQQ shares held by investors.

New Trend?

Should we therefore expect to see a trend away from the use of index names in product titles in an attempt to circumvent licensing requirements? Although this may happen, so far there appears to be no sign of this in the European ETF market. Indeed, one index provider told IndexUniverse.eu that Commerzbank, while in dispute with the Deutsche Boerse over its index certificates, has continued to pay licensing fees for the use of other indices within its Comstage ETF range. However, there is clearly no room for complacency amongst the licensors.

Meanwhile, the index providers appear to have developed other competitive strategies to counter the threat to their bread-and-butter business. One is to highlight the importance of an independent third party, responsible for the verification of pricing and overall index calculation, in the relationship between the ETF issuer and investor. FTSE, for example, stresses in its marketing literature that its index methodology is “rules-based” and objective.

Another strategy is to press home the importance of the index provider’s own brand as part of the overall investment offering.

A third is to move into higher-margin, value-added “strategy” indices, where a specific investment policy forms part of the index and where the index provider is better able to claim that its work constitutes valuable intellectual property.

A fourth response by the index providers might be to threaten to stop calculating certain indices altogether if their right to receive licensing fees were curtailed, although one observer questioned the substance of this threat, noting that indices were around long before index-based investment products. Such a course of action would undoubtedly also require coordination between index providers, given that they compete with each other to offer coverage of the same markets and sectors.

Only time will tell how these trends play out and what impact the recent German court ruling will have. But, as Jonathan Mazer states in a recent article, “index-based financial products are not going away, and neither are questions about who in the world owns financial indices and precisely what rights they have.”

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