The following is a guest article from Amrish Ganatra, Managing Director of Commcise, a London-based provider of commission management software.
Now that the European Commission finally published the long awaited Delegated Acts (DA), asset managers are relieved that language permitting the use of commission sharing agreements (CSAs) has been included. However, market participants should not assume that CSAs as we know them today will be acceptable under the new MiFID II regulation.
The key driver behind the Delegated Acts is greater transparency around commission payments for research. The regulator wants to ensure that:
- end clients know exactly what they are paying for;
- a clear separation exists between research and trading activity; and
- research cannot be provided as an inducement to trade.
Research payments will continue to be client funded
The EC’s preferred solution is for firms to pay for research from their own P&L; they believe this removes the risk of inducements (even if the firm then recovers those costs by increasing customers’ fees!)
However, our conversations with asset managers suggest that fewer than 10% of investment firms will adopt this P&L approach; typically those with a research budget of less than $1m or so. Such firms have often cited cost/benefit reasons for moving to a hard dollar model.
The majority will opt to pay for research out of a separate Research Payment Account (RPA) that they control, funded by client money specifically allocated for this purpose. Whilst many asset managers currently operate Commission Sharing Agreement (CSA) programmes, RPAs are designed to enhance the controls around commission spend, which currently tend to exist simply as CSA budgeting and monitoring processes at the discretion of internal teams.
The published DA clarified that an RPA can in fact be funded by a “separately identifiable research charge” alongside a transaction commission [Article 13 (3)]. This was one of the most widely awaited clarifications within the whole paper as this confirms that conceptually a Commission Sharing Agreement (CSA) style funding mechanism may be used to fund an RPA.
Differences between RPA and CSA
The EC have stipulated that when an investment firm uses a transaction to fund an RPA, then a number of conditions must be met. These conditions can be grouped into three high level categories of: (i) Funding (ii) Research Quality Assessment and (iii) Reporting. The detailed requirements are listed below:
- The RPA must be controlled by the investment firm;
- The RPA is funded by a specific research charge to the client;
- The investment firm must set and regularly assess a research budget as an internal administrative measure;
Research Quality Assessment
- The investment firm is held responsible for the RPA;
- The investment firm regularly assesses the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions;
- On an ex-ante basis [before the provision of an investment service to clients], the investment firm must provide information about the budgeted amount for research and the amount of the estimated research charge for each client [or fund];
- On an ex-post basis, the investment firm must provide annual information on the total costs that each client [or fund] has incurred for third party research.
These additional requirements signify that CSA as we know them today do not automatically translate to an RPA. To understand why, we must consider each of the conditions above in the context of today’s CSA arrangements.
In theory CSA’s are controlled by the asset manager, but in practice controls may be limited. We have heard of cases where an investment firm might accept a broker’s version of a CSA balance without reconciling. Or, a reconciliation is conducted to confirm to total month end balance matches not trade by trade. In other examples one party performs the reconciliation based on the other party’s data.
In order to control a CSA, the investment manager must exercise direction over these funds, which we interpret to mean that a trade by trade reconciliation would need to be conducted. Absent trade by trade reconciliation, asset managers are delegating too much control to the CSA provider.
Funding by a specific research charge
CSAs comply with this requirement at a basic level. Every eligible trade represents a research charge being applied to the fund that was transacted. It is common for CSA agreements to detail the eligibility criteria that apply to the given arrangement and specific funds may be included or excluded from the agreement.
When a fund is excluded, this is only understood post-trade and the current practice is for the broker to keep the full service rate and the CSA account would not be credited. We believe this practice might need to be re-considered when operating within the bounds of an RPA.
As an observation, it also worth pointing out that from a reconciliation standpoint, most aggregators usually consider CSA eligible trades only and therefore any ineligible trades are not considered, which potentially creates issues for client-level tracking and reporting.
CSA arrangements as we know them today don’t typically consider a research budget. To understand this requirement, it’s important to be clear on the level at which investment firms must manage their budgets. The language in the Delegated Acts talks about clients, but to accurately monitor commission spend at the individual client level is generally out of practical reach for most large investment firms. This is because there are often hundreds or thousands of clients in a given fund who can change on a daily basis.
The newly published DA appear to have softened their requirements for budgeting. The text now states that: firms should regularly assess research budgets as “an internal administrative measure”.
Our interpretation of this is that budgets will not need to be managed at the client or fund level. Investment firms must create an estimated research charge for every fund or client – this charge will be an estimated allocation of the firm-level research budget.
Our understanding is that there is no regulatory obligation on the investment firm to notify or obtain approval from a fund or client in the event that this estimated research charge is exceeded during the course of the year. The investment firm does however have a regulatory obligation to notify its clients if the firm-level research budget is breached. The summary is that a requirement for budgeting is something that investment firms will need to consider in more detail over the coming months. We believe that investment firms will require the ability to manage research budgets at a more granular level in order to demonstrate they have adequate control and governance over their total research spend.
CSA’s are already the responsibility of the investment firm however the line between where the investment manager is responsible and where the broker or aggregator is responsible are not always well defined. As an example, it is commonplace for brokers to hold CSA balances on their own balance sheets when holding these funds on an asset managers’ behalf.
We don’t believe such practices will be acceptable in the event that a broker wishes to administer an RPA on behalf of an investment firm. We believe that RPA administrators will need to hold research funds in a separate “ring-fenced” client account. This would ensure that the investment firm (or ultimately their end clients) are not out of pocket in the event that the RPA broker was to default.
Research quality assessment
CSA’s have no regulatory requirement to ensure research funds comply with any level of quality assessment. This is a new requirement that means CSA’s in isolation without a robust research evaluation platform would not be considered compliant. The broker vote will still have a role to play, but it also will need to evolve, as Integrity Research has discussed previously [subscription required for link].
CSA’s don’t have any regulatory reporting requirements either on an ex-ante or ex-post basis. The UK adopted a client reporting standard, Level II Disclosures, following the Investment Management Association’s best practice guidance on the subject. It appears that the new reporting requirements within the DA will supersede the Level II Disclosures in the UK. The important consideration for investment firms is that existing CSA administrators may struggle to deliver this requirement because (i) they typically only see eligible CSA trades (ii) may not see other asset types (iii) don’t have visibility on priced research consumption by fund (iv) don’t have visibility on the research evaluation process and how this links back to funds or clients.
In conclusion, we believe that in Europe, CSA’s will most likely require a tighter control and governance framework in order to become RPA compliant. Even when compliant, the role of the CSA is limited to providing funding, and does not address the reporting and quality assessment requirements of the new regulation.
We believe that CSA’s and RPA’s may in fact coexist in Europe. The number of CSA and RPA providers that a firm retains is unlikely to be consistent across the industry. Every firm is likely to make this decision based on a number of factors that are relevant to their firm.
As an example, firms will decide on the most appropriate approach to funding their RPA. We believe there are two methods that asset managers can choose to fund an RPA: (i) the transactional method; and (ii) the accounting method. The transactional method uses a research charge that is included alongside a transaction (or trade) to fund an RPA. The accounting method on the other hand uses a fixed charge that is applied to each fund and is most often accounted for as a daily accounting “accrual”. This daily accrual would eventually be transmitted to the asset managers chosen RPA administrator(s) at a pre-agreed frequency (often monthly or even quarterly) so that the RPA administrator can complete all payments for research from this research balance.
However, it is noteworthy that solving the funding challenge alone does not make a firm RPA compliant. The investment firm must additionally evidence that they have regularly assessed the quality of research they’ve consumed against agreed quality criteria and have ensured that they have only paid for research that has helped the firm to make better investment decisions for its clients. They also must have the ability to provide reports to clients detailing where research dollars have been spent and how these amounts were justified. A fully integrated research evaluation and consumption tracking solution that considers holistic view of research spend across the firm (including other asset types) is what will eventually be required.