As we predicted, the revised MiFID II rules have backed away from an outright ban on paying for research with client commissions. BUT, and this is a big but, the proposed MiFID II regime has very stringent conditions on the ability to pay for research with client commissions which go further than any regulator has gone so far, including the aggressive UK regulators. If adopted, and chances are good it will be, the research industry will be changed significantly, not only in Europe but globally.
The Revised MiFID II Guidelines
The European Securities and Markets Authority (ESMA), the European regulator whose members are the financial markets regulators in each of the 28 member states, has released revised technical advice on the implementation of the Markets in Financial Instruments Directive (MiFID II). The advice can be found here. The relevant sections for investment research are pages 130 – 134, which are the discussion, and pages 139 – 141, which are the proposed regulatory language.
Even though the majority of respondents to ESMA’s initial Consultation Paper opposed the idea that research is an inducement, ESMA insists that bundling research and execution commissions represents an indirect payment structure which qualifies as an inducement. However, investment firms may continue to use client commissions to pay for research provided they set up a research payment account funded by specific research charges billed to the investment firms’ clients.
The research charges funding the research payment accounts must be based on a research budget set by the investment firm and cannot be linked to the volume and/or value of transactions executed on behalf of the clients.
Under the proposed rules, the investment firm must agree with each client the research charge as budgeted by the firm and the frequency of the research charge. The investment firm may only increase the research budget with the client’s written agreement. If there is a surplus in the research payment account at the end of a period, the surplus should either be rebated or applied to the following period.
Research budgets must be managed solely by the investment firm with senior management oversight. The budgets need controls including a clear audit trail of payments made to research providers and how the amounts were determined.
The investment firm should regularly assess the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions. Firms will also need to address the extent to which purchased research benefits clients’ portfolios taking into account the portfolios’ various investment strategies. Research costs need to be allocated as fairly as practical to the various clients’ portfolios. The whole process must be documented in a written policy.
Commission sharing agreements (CSAs), which allow asset managers to pay an executing broker for trade execution while separately allocating a portion of the commission to pay a research provider, will be integral to the proposed MiFID II regime. CSAs will be the primary mechanism for implementing the research payment accounts described in the technical advice.
ESMA states that commission sharing arrangements (CSA’s) have elements that address the conflict of interests between brokers and portfolio managers in respect of research. However, ESMA makes it clear that CSAs alone do not meet the new MiFID II requirements: “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.” Hence the emphasis on budgeting in the technical advice.
ESMA takes a couple of shots at investment banks. First, it says that research pricing should be unbundled, with brokers providing separately identifiable charges for research. However, investment banks are not governed by MiFID II, so the technical advice threatens separate regulation: “Future ESMA guidelines may also be useful in this area.”
ESMA also calls on the European Commission to address the conflicts between investment banking and research, an area where European regulation lags the U.S.
Timeframe and Scope
The revised draft language in the latest ESMA release will be open for comment until March 2, 2015. After that, ESMA will submit its final technical advice for endorsement by the European Commission by January 2016 and the final rules will go into effect from January 3, 2017.
MiFID II applies to investment firms managing separate accounts. ESMA advises the Commission to include the new rules for research payments into UCITS and AIFMD so that the same regulations pertain to managed funds and hedge funds.
Although many are relieved that a ban on research commissions has been averted, the reality is that the proposed MiFID II regime will radically change the research payment process. First there is the matter of budgeting, a rare practice as the UK Financial Conduct Authority (FCA) found during its thematic review earlier this year . Asset managers will need to determine in advance how much they are willing to pay each broker who supplies research, and cap payments at that amount. The aggregated budget amounts will determine the research charges levied on an investment firm’s clients.
Which leads to the second big change: signoff from clients. To increase the research budget, investment firms will need written agreement from clients. If performance is good, presumably clients will be accommodating. Getting approval during difficult markets or when providing indifferent returns will be more challenging. This will make it harder to grow research payments.
Conversely, the budget process will tend to provide a floor as well as a ceiling on research revenues. Asset managers have an incentive to spend all they budget rather than rebate the excess or roll it over to the next year.
Administratively, asset managers will need to track research commissions down to the fund level, even though overall budgeting will be done at an aggregated level. Broker votes as currently constituted have some use, provided they now allocate the research charges rather than overall commissions, but they do not currently address the budgeting and client signoff processes.
Many asset managers think of the vote as allocating a percentage of commissions. This way of thinking is obsolete. Asset managers will need to think of the absolute amounts paid away, and presumably this will lead to thoughts of relative value received from the various providers.
In theory, if investment banks provided explicit research pricing as ESMA is encouraging, broker votes would not be necessary. However, while banks may provide marginally more transparency, we doubt that it will be sufficient to obviate the broker vote anytime soon. Also, broker votes help to satisfy the requirement of assessing the quality of research provided, even though votes do not address the benefits at the client portfolio level.
Client behavior is a wild card in the new budgeting/approval process. Currently, pension funds that receive the Level II commission disclosures in the UK simply file them away. Will asset manager clients become more engaged in the new regime? They will need to sign off on any increases, but otherwise may as indifferent as they are to the Level II disclosures.
Balky clients do raise the ‘free rider’ problem for asset managers. If a client refuses an otherwise approved increase in the research budget, does the recalcitrant client get a different level of service?
The new regime will be positive for CSAs, which will become nearly mandatory. CSAs will be the preferred vehicle for managing the research payment accounts.
A big issue not addressed by ESMA is VAT. Currently, bundled research is exempt from VAT. The MiFID II regime will explicitly unbundle research payments, making research vatable. This may be the biggest concern for research providers, potentially lopping off 20% of research payments at one whack.
Investment banks will not benefit from the new guidelines, except as CSA brokers. Unbundling hurts equity commission revenues. Adding insult to injury, ESMA is threatening tougher conflict rules between banking and research. On a relative basis independents benefit from a more level playing field, but they are also subject to the overall constraints on payments from the budgeting process. Research becomes even more of a market share game than it is today.
Although there is yet another comment period ahead, we suspect the final rules will be close to the current draft rules. ESMA has backed away from the full ban as European legislators requested, and it is proposing guidelines that will accommodate CSAs and improve transparency. Asset managers will winge about the administrative burden, but ESMA can simply respond, ‘if you don’t like the process pay out of your own pocket’. VAT is a big concern, but unlikely to be a deal breaker.
The proposed MiFID II payment regime will likely have a bigger impact on non-EU markets than an outright ban. If ESMA had stuck with a ban, the likely response would have been regulatory arbitrage, as is happening now with the FCA’s ban on commission payments for corporate access. However, the budgeting/approval process will be adopted by global asset managers and implemented in all domiciles, U.S. included. It will take time, and the proposed regime would not go into effect for two years, but its effect will be profound and far-reaching.