The UK Financial Conduct Authority (FCA) issued a statement today clarifying its interpretation of proposed European regulation governing the payment for investment research with client commissions. As we have previously reported, the FCA interprets the pending MiFID II regulation as banning the use of client commissions for the payment of investment research. The statement reveals a confused view of commission sharing agreements (CSAs) and acknowledges taxation problems with its approach. It also contains an implied threat to implement its preferred regime irrespective of the final European regulation.
As we have discussed previously, a key issue in the interpretation of the pending MiFID II regulation is whether CSAs would be a permitted vehicle for research payment accounts envisioned in the new regulation. It is no surprise that the FCA thinks not. “In our view, the intention of the technical advice is to create a ‘hard dollar’ research market, with the option for research invoices to then be paid either by the investment firm itself, or a from a research payment account linked to the client portfolio that has benefitted (sic) from the research received.”
It appears that the FCA views CSAs as linking research payments to commissions rather than separating research payments from execution, as they were designed to do. In their current form, CSAs unbundle commissions into a research component and an execution component, allowing asset managers to direct the payment of the research component to the research providers it designates.
In fact, if we look at the FCA’s own description of the ideal research payment process, we see that CSAs are compatible with all provisions but one: “In the technical advice, ESMA proposes that the research payment account and charge should be agreed upfront between the portfolio manager and their client, and be based on a budget set by the firm relating to their external research needs and not linked to trading volume or values. It also requires the portfolio manager to be responsible for operating the research payment account and managing the allocations made from within their budget.”
While asset managers are responsible for overseeing the CSAS and managing the allocations, technically the CSAs are operated by the investment banks. However, the FSA believes that “tools developed in the context of CSAs – such as software platforms to manage these accounts” are “transferrable (sic) to managing the new research payment accounts ESMA proposes.” It seems inconsistent to allow asset managers to use third party software providers to manage the research payment accounts, but not investment banks.
Fixed Income and other non-equity markets
The new regulation would apply to all asset classes, not just equity. Fixed income, commodity and currency research would have to be paid for separately, and unlike in equity markets where there are unbundling mechanisms like CSAs in place, there is no precedent for this. Trading in these markets is largely principal-based, with the deal’s spread paying for any research provided. The FCA believes that spreads would narrow, but there is no prior experience to substantiate this. Given increasing capital pressures on banks, there are concerns for liquidity and market making if spreads narrow further. A more likely outcome would be reduced levels of non-equity research.
Since we have already expressed at some length the drawbacks we see in the FCA’s position, we will not repeat them here. Let us instead look at the FCA’s responses to industry concerns.
- Taxation. The FCA’s regime would subject all research payments to VAT. The FCA argues that this would level the playing field for independent research providers currently paid with hard dollars. [Note: our surveys suggest that approximately half of IRP payments are through CSAs and on average around a third are cash payments.] While IRPs appreciate the FCA’s intent, they are concerned that a 20% whack to overall research payments will result in lower payments irrespective of payment method.
- Competitiveness with non-EU asset managers. The FCA’s view is that “a more competitive research market has the potential to lower costs and improve returns to customers, which should make EU investment managers more rather than less competitive.” We think the FCA is optimistic. We suspect regulatory arbitrage is a more likely outcome, as asset managers shift research payments to domiciles which allow commission payments.
- Competitiveness of smaller asset managers. The FCA thinks that smaller asset managers would not be disadvantaged under its regime because the research fees will be viewed as distinct from the annual management charges. However, since the hard dollar research fees would be calculated similarly to the AMCs it is very likely that asset owners and their pension consultants would view the research fees similarly to the AMCs. This would harm smaller asset managers who are unable to fund the research payments out of current AMCs, but also would significantly shrink the overall budgets for research in the domiciles where the FCA’s regime is implemented.
Believe it or not, we are very sympathetic with the FCA’s desired goals of improving transparency and fostering a more competitive research marketplace. If the FCA had the support of its American cousins, perhaps there would be some chance of effective implementation of its brave new world. That, however, ain’t happening. If the FCA pushes the envelope too far, the ends will be self-defeating, just like its ban on payment for corporate access with client commissions. On the other hand, if the FCA were able to moderate its position slightly to permit CSAs as a vehicle for the research payment accounts, then it is likely that the controls it desires — budgeting and client engagement — are likely become global best practice.
However, its latest statement reinforces the impression that it will be the FCA’s way or the highway. The FCA not too subtly indicates that if the EU regulation is not to its liking, it will implement its regime even if it is UK only. That smacks of petulance rather than regulatory wisdom.