Here is the latest on proposed regulatory restrictions in the UK on commission payments for corporate access and a potential ban on payment for research with client commissions generally. The good news is that there seems slightly less concern that regulators will prohibit research commissions altogether, but the current read is that regulators are unlikely to soften the proposed limits on commission payments for corporate access.
Corporate access and primary research
From what we have heard, UK asset managers are resigned to a ban on payments for corporate access with client commissions. Although briefing notes or a research analyst’s input before a corporate access meeting would be eligible for payment with client commissions, payment would be limited to that component only, not the entirety of the arranging service. Thus the bulk of corporate access payments would need to be paid for out of the asset manager’s pocket or clients would have to be explicitly billed for corporate access costs as add-on fees.
As we noted earlier, primary research and market data would also potentially be impacted. Expert consultations, channel checks, surveys and other forms of primary research often do not include analysis and insight as part of the service. As with corporate access, any component providing insight would need to be unbundled and paid for separately. Similarly, market data services would also have to bill separately for its ‘substantive’ research components with the bulk of market data feeds paid by asset managers with their own monies.
How big a change?
Some commentators believe that the definition of research proposed in CP 13/17 is a significant change from the rules implemented in 2006. It is true that the FCA is proposing the concept of “substantive research”. However, the four components which define research eligible for payment with commissions are largely unchanged from 2006. As before, to be payable with client commissions research in the UK must provide: 1) new insights, 2) original thought, 3) intellectual rigor, and 4) meaningful conclusions involving analysis and manipulation of data. It is unclear how corporate access, consultations or raw surveys have ever met those definitions. “Substantive research” seems merely a label the FCA is using to underscore its research definitions, which are the same as in 2006.
Also unchanged from 2006 is the explicit intent that client commissions should not be paid for internally generated research. From the original rule: “It [commission payment for execution or research] has no application in relation to research generated internally by an investment manager itself.” This further complicates the argument for payment of primary research with client commissions.
Overall, our sense is that industry generally accepts the FCA’s view that CP 13/17 is a clarification of existing rules rather than substantive new rules. The industry expects that more rules are to come, and that is the real concern.
The Investment Management Association and its blue ribbon panel are working to complete a review of the research market by the end of January. It is expected that the IMA paper will outline industry best practices with the goal of convincing regulators to maintain the current commission regime pending industry improvements. It is likely the IMA will recommend improved procurement policies with more explicit budgeting for external research and better voting/valuation measures. The industry seeks to break the pattern of automatically paying more for research when trading volumes increase, and expects that the total commissions spent on research will decline in the future from more rigorous procurement discipline. The IMA will probably call upon investment banks to provide more transparency on pricing of its different service levels rather than explicit pricing of all research components.
As we noted previously, the IMA leadership seems willing to throw corporate access under the bus in order to maintain credibility for the current commission regime. The FCA has explicitly welcomed the IMA review and has signaled that the IMA will have an impact on whether it decides to move forward with a complete ban on commission payments for research.
The FCA noted in its consultation paper that negotiations to revise MiFID were underway, and there was speculation that the MiFID II discussions were providing some of the urgency behind the FCA’s actions.
The relevant part of MiFID II is a potential ban on inducements paid or received by investment advisors. The provision was partly intended to develop consistent rules governing rebates to independent advisers distributing asset management products, but could have a much broader reach. Rebates to financial advisers were banned in the UK a year ago, but for the rest of Europe there are conflicting practices and regulations.
Current MiFID regulation has rules governing commission payments to third parties, but the draft directive bans third party inducements altogether, potentially impacting commission payments for research as well as the intended restriction on rebates to financial advisers. See this Linklaters’ publication for a summary of existing and proposed inducements regulation.
MiFID II is the subject of trialogue discussions between the European parliament, European Commission and European Council. The commission favors a full ban on inducements, while the council and parliament would like the ban to apply only to independent advisers. Apparently, there was language proposed that would explicitly exempt payments for research, but this language was rejected.
Because no agreement was reached by the end of 2013, the topic will be delayed until the next European parliamentary elections in May, 2014. The FCA now has more breathing room to formulate its own policies.
The investment banks
The investment banks, who were feeling like wallflowers in this debate just a few months ago, now have the FCA crawling through their undergarments as part of its thematic review. The FCA is scrutinizing sell-side practices as part of its examination of bundled brokerage arrangements. What the FCA finds could have a big influence on how the regulation ultimately plays out. If the FCA finds evidence that commission payments influence IPO allocations, likely followed by the usual media hysterics, all the IMA’s hard work to contain the issue may be for naught.
The investment banks are understandably reluctant to provide more transparency in the pricing of their research services. The current process allows banks to maximize revenues by telling each asset manager it is underpaying for the research it consumes. Nevertheless, investment banks, now faced with declining commissions from a proposed ban on payments for corporate access, have a legitimate concern about how deep a hit they will be taking to their already fragile equity businesses. They will argue to the FCA that if it pushes too hard, equities markets will suffer from more banks downsizing their equities businesses.
EuroIRP, which likely started this whole mess with its 2011 report challenging whether corporate access met the UK definition of research, is now in a quandary. Having sicked the regulatory dogs on corporate access it now finds the topic has grown to very uncomfortable proportions. EuroIRP’s U.S. counterpart, Investorside, is planning to also weigh in and has similar qualms.
By our estimates, independent research in aggregate lost market share to investment banks during the post-crisis decline in commissions. It is therefore understandable that independents quail at the prospect of further commission declines.
In principle, an outright ban on commission payments for research would provide a much more level playing field for independents than currently exists with bundled investment bank research. However, independents have recently seen investment banks favored during a declining commission environment, and worry that investment banks have a greater ability to cross-subsidize their research.
The good news is that the independents have a seat at the table. The FCA seems sympathetic to independent research, recognizing that independents already provide more transparency than bank research. The FCA has stated as one of its goals the creation of a more competitive research marketplace, and wiping out independent research is not a good step in that direction.
As we have noted previously, the head of the FCA is highly engaged, believing that significant reform to the current regime is necessary. Those who have interacted with FCA staff sense that intellectually they favor a ban on research commissions but would be happy if the result is achieved organically rather than through regulation.
The FCA’s leadership position relative to its European counterparts has been undermined by the UK’s greater distancing from the EU over the last few years. In some ways, a ban resulting from MiFID’s inducement language would take the onus off the FCA, allowing it to put the blame on its European counterparts. However, the FCA shows every sign of wanting to drive the bus on this issue rather than having the issue become European roadkill.
Investment banks, investment managers and other power brokers hoping to influence the FCA on the topic would likely go through the Treasury Select Committee, which is a committee appointed by the House of Commons to review the FCA, along with HM Treasury, the Bank of England and other finance-related public bodies. Committee members might be sympathetic to arguments that banning commission payments for research would create an unlevel playing ground for UK asset managers and batter UK investment banks. However, any additional abuses surfacing as a result of the FCA’s thematic review could quickly neutralize such efforts.
Some U.S.-based research providers, including U.S.-based investment banks, have awoken with a start to this issue which has been brewing for well over a year. The Americans are ready to apply their ‘can do’ spirit to trying to prevent a UK ban on corporate access. Our sense is that the UK institutions have largely accepted CP 13/17 as a fait accompli and are more focused on containing regulatory zeal for further reforms to the commission regime.
At the same time, UK sources sound a bit more sanguine that the FCA will give the industry time to implement best practices before pressing on with further reforms, and that European intransigence will allow the UK maintain some level of leadership on the issue. However, the wild card is the FCA thematic review which could fold the IMA’s hand.
Next out of the box will be IMA’s report, expected around the end of this month. The comment period for CP 13/17 ends February 25, 2014. The FCA intends to implement CP 13/17 later in the spring of 2014 and expects to release the results of its thematic review after the implementation of the changes proposed in CP 13/17. Stay tuned.