The European Commission (EC) recently issued a draft of pending new regulation which shows concessions on client sign off on research budgets, but no change in the language banning the linkage of research payments to client commissions. Although the interim draft does not preclude further changes before the final rules are released next month, it raises the odds that the new European regulation will completely sever the links between research and trading commissions.
Draft of new regulation
The EC’s Directorate-General for Financial Stability, Financial Services and Capital Markets Union (DG FISMA), which is responsible for drafting the final MiFID II rules pertaining to research payments, issued a draft version on April 16, 2015 in preparation for a meeting with outside experts who advise the EC, The Expert Group of the European Securities Committee (EGESC). Here is the document: EC MIFID II Investor Protection Issues Draft 16.4.15; the relevant text begins on page 13.
Minutes of the April EGESC meeting during which the draft was discussed are not available yet but a previous meeting’s discussion can be found here starting on page 3 under the heading ‘Inducements’.
Client notification of research budgets
When we compare the April 16th draft to the initial European Securities and Markets Authority (ESMA) rules released in December, there is only one material change. Previously, investment firms were required to agree budgeted research charges with each client. In the latest version, the investment firm “must agree with clients, in the firm’s investment management agreement or general terms of business, the research charge as budgeted by the firm…” Whereas the initial version required written agreement from clients for any increase in research budgets, the current version allows increases to take place “after the provision of clear information to clients of such intended increases.”
In other words, research budgeting can be a top-down process rather than bottom-up, greatly simplifying the research payment account (RPA) mechanism. Further, fee increases become more feasible if simple notice is sufficient, rather than requiring written agreement from each client.
Commission sharing agreements
Starkly absent is any change to the current language forbidding a link between research payments and “the volume and/or value of transactions executed on behalf of the clients.” Many industry participants, including the French regulator L’Autorité des Marchés Financiers (AMF), have hoped that commission sharing agreements (CSAs) might be permitted under the new regulation. They propose that caps on CSA spending might satisfy the intent of breaking the link between research payments and commission volume.
However, investment firm compliance staff are more likely to agree with the UK regulator, the Financial Conduct Authority (FCA), that the language as drafted precludes any tie between client commissions and research payments.
The April 16th draft included language inviting additional input: “Are there further operational adjustments that are necessary or helpful in limiting the impact of these measures whilst preserving the objectives of breaking the link between the purchase of research and the payment for execution and of disclosure regarding the costs of research?”
On its face, the EC seems to be leaving the door open and industry groups, which have been lobbying the EC since December, once more jumped into the fray. However, it is not clear why the EC would accept industry arguments at this late stage after apparently ignoring them up until now.
Some members of European parliament (MEPs) have been vocal in opposing a ban on using client commissions to pay for research, so it is possible that political pressure may sway the EC. That is assuming there are enough MEPs willing to vote against adopting MiFID II over this issue.
The EC is widely expected to issue the final rules in June so at this point the clock is working against those seeking to soften the rules. Because the EC is taking a hard line at this late date, any concessions are likely to be small, such as allowing CSAs for some interim transitional period.
It is not clear how important CSAs are to investment managers at this point. The industry felt passionately that increasing fees to pay for research was not possible, but that position seems to have softened significantly. Some of the larger asset managers believe they have the wherewithal to pay for research out of their own pocket, thereby exempting themselves from the costs and scrutiny associated with RPAs.
The concessions in the latest draft which allow fees to increase through client notification rather than through written agreement will give further comfort to investment managers that they have sufficient latitude to pass along research costs to clients.
The nail in the coffin might be that some asset managers are reportedly already implementing RPAs. We understand that three of the largest Swedish pension funds have decided to go the RPA route. Two are implementing the RPAs in-house while the third plans to use Instinet, which recently applied to the FCA to be a payment institution. If the Swedes can do it, why not the rest? Or at least, that will be the regulatory logic.
We previously put the probability CSAs being permitted in the final rules as a coin toss. At this point, it looks more like a Hail Mary.