“The Markets in Financial Instruments Directive is the EU legislation that regulates firms who provide services to clients linked to ‘financial instruments’ (shares, bonds, units in collective investment schemes and derivatives) and the venues where those instruments are traded.”
Financial Conduct Authority (FCA)
Across Europe, MiFID II will change the way financial intermediaries operate. In respect of the provision of research, European rules are likely to be at odds with US rules on inducements.
What Is Happening?
Most financial research is provided freely at present, from January 2018 it will have to be unbundled. The cost of execution, settlement, custody and research will become separate items. Intermediaries will be forced to respond rapidly, but buy-side firms will also need to establish systems for measuring the incremental value-added by each research provider. The investment research market will transition from a push to a pull model as asset managers are transformed from passive research consumers to active research buyers.
Under Articles 24(b) and 24 of the MiFID II Directive, EU investment firms providing portfolio management, or investment advice, are not permitted to accept fees, commission or any monetary or non-monetary benefits from third parties in relation to the provision of services to clients. Such fees or benefits are inducements and thus create conflicts of interest between investment firms and their clients.
Investment firms may accept “minor non-monetary benefits” that do not materially impair compliance with their duty of care to clients. European Securities and Markets Authority (ESMA) “Final Advice” took the view that investment research that is tailored or bespoke in its content or rationed in how it is distributed or accessed cannot be a “minor non-monetary benefit.” ESMA recommended
ESMA recommended that for investment research not to be an inducement, investment firms must either: pay for the research directly with their own funds; or pay for research from a designated research payment account (RPA), funded by specific charges to their clients.
Where an investment firm uses an RPA, the Directive requires that:
- the RPA be funded by a specific research charge to the client – which cannot be linked to the volume/value of transactions executed on behalf of the client;
- the investment firm must set and regularly assess the research budgetThe research budget must be agreed with each client;
- the research budget must be agreed with each client;
- and the investment firm must regularly assess the quality of research purchased and its ability to contribute to better investment decisions;
The investment firm must also provide its clients with detailed information about the research budget, actual research costs, the providers of research, the amounts paid to research providers as well as the benefits and services received from those providers. Neither the RPA not research budget may be used by the investment firm to fund internal research.
The Directive requires investment firms to agree with clients:
- the annual research budget;
- the annual payment schedule for providing research;
- the annual payment schedule for providing research;
- that any increase to the research budget be notified in advance;
- that there be a written agreement with each client detailing the budget and any increase;
- and that a process is in place for the rebate of any unused RPA balances.
Under the Directive, investment firms must have a written policy in respect of investment research which covers the extent to which research purchased through an RPA may benefit clients’ portfolios including, where relevant, consideration of the investment strategies applicable to the various types of portfolios and the “approach the firm will take to allocate such costs fairly to the various clients’ portfolios.”
It is little wonder that several investment managers have already opted to absorb the cost of research directly rather than passing this cost on to their clients. Apportioning the cost of research across all of an investment firm’s clients “fairly” is likely to prove extremely difficult. The risk of clients seeking legal redress – with the associated reputational risk – is also extremely high.
Impact on Commission Sharing Agreements (CSAs)
ESMA takes the view that the
“current use of CSA’s by industry still enables amounts charged for research by the investment firm to be determined by the volume of transactions of the investment firm with the executing broker, although some investment firms apply budgets to control the total amounts accrued in CSAs. Also, CSAs do not guarantee a fair allocation of research costs to the client’s portfolio.”
For a CSA to be compliant with the new regulations it would need to be agreed under the same terms as an RPA. The vexed question of volume/value of commission paid is an administrative and compliance challenge. How much easier to unbundle “investment research” as a separate item or cease to offer investment research at all? It seems probable that the CSA, as we currently know it, will soon be dead.
Brokers must identify separate charges for execution and other services. Furthermore, the cost of other services must be independent of the volume or value of execution services.
Whilst these rules only apply to EU brokers services to EU clients it is unlikely that they will apply different policies to non-EU customers because these clients would have recourse to litigation under existing EU rules relating to “treating customers fairly”. If a non-EU customer executes business and receives investment research on an unbundled basis this may afford them “preferential treatment”.
Fixed Income and OTC Derivatives Markets
Most fixed income and OTC derivatives markets, including Foreign Exchange and Interest Rate Swaps, trade on a net basis – the cost of dealing is inherent in the bid/offer spread. Neither ESMA’s Final Advice nor the Directive addresses this issue.
However the FCA states
“We believe this would mean that, in the new regime, a manager would have the option either to pay directly for research, or use the research charge and payment account to do so, which can be applied to clients with fixed income portfolios in the same way as for equities. If research is currently a material part of a broker’s costs, we would expect a narrowing of spreads as a result of the decoupling of research from trading spreads. Transaction cost analysis software may help fixed income and OTC derivative operators to show the differential cost of execution, but it may prove easier for investment managers to absorb the cost of research rather than defend their policies of research cost redistribution.”
Solutions and Market Impact
The financial research market is currently divided into bundled research providers, affiliated with banks and brokers, and independent research providers. MiFID II will unbundle the cost of research whether it is provided from a tied or independent source. The largest institutions will probably continue to offer their global research products. The intermediate providers will be forced to specialise or exit the gene pool.
FT Adviser reported in October that
“the unbundling of research costs required under Mifid II could wipe nearly 30 per cent from fund house profits.”
A November 2016 report from Crisil sees the following trends:
“1. Research costs for AMs (Asset Managers) will fall as they budget their requirement better.
2. Most large AMs will opt to absorb research costs, rather than go through the strenuous process of setting up RPAs.
3. AMs will choose specialists for execution and research.
4. AMs will optimise their research procurement mix by leveraging bulge-bracket brokers for the breath of coverage; boutique/regional firms for the differentiated insights; and third party service providers for bespoke research and as an extension of their onshore teams.
5. There will be a greater thrust on technology and outsourcing as AMs look to reduce margin pressure.”
Technology is already delivering solutions. Companies, such as RSRCHXchange, are providing the procurement, management and cost analysis investment managers need to turn CSAs into compliant RPAs. As Vicky Sanders, Co-founder of RSRCHxchange stated in a recent interview:
“The biggest challenge for the banks and brokers isn’t necessarily paying for research. It’s all the oversight that is associated with it.”
Specialist consultants, such as Substantive Research, have also emerged, to guide buy-side institutions through the challenges of complying with MiFID II requirements.
Research as Marketing
Most independent research providers allocate a part of their output to marketing. They provide content as an “invitation to treat”. This is a model which some tied research providers may contemplate. The difficulty will be justifying this cost to the regulator. Larger asset managers already have marketing and communications departments which create investment performance and thought leadership content with the express intention of brand enhancement. It is difficult to justify a substantial increase in the budget for these departments in order to maintain the research department headcount by stealth.
A Year of Catharsis
The remainder of 2017 will be a fraught with challenges. Joshua Maxey, Managing Director of Third Bridge, writing for The Market Mogul – The MiFID II Uphill Battle: Five Years Of Work To Do In 200 Days, makes the following observation:
“Asked by a financial regulatory consultancy about their plans for MiFID II, wealth managers recently said they would need an eye-watering 1,363 working days on average to meet the new requirements – and that’s excluding the necessary IT development.”
Banks and brokers will start to transform their research departments. Their compliance departments will create processes to enable them to comply with MiFID II regulations when they come into force on 3rd January 2018. Investment management firms will also begin to respond, seeking independent advice from transaction cost analysis consultants. The unbundling of investment research is one of the largest changes in the operation of the investment business since the end of fixed commissions on the NYSE in May 1975 or the big bang of the LSE in October 1986. The principal beneficiary will be the end investor, whose cost of dealing will be substantially reduced at the expense of the investment industry or its employees. Many investment companies, however, have not yet begun to plan ahead.
2017 is already and will continue to be a year of catharsis.