The following is a guest article by Melissa Umans, US Director of Business Development for Commcise Software Limited, a provider of commission management software.
Paying US-based broker-dealers for research is not without challenges for UK-based asset managers.
In Europe, MiFID II requires buy-side firms to pay for research either as a direct payment from their P&L or from a ring-fenced Research Payment Account (RPA). For a US-based broker dealer to accept payments in hard dollars or through MiFID-governed research payment accounts from MiFID-affected clients, under the Investment Advisers Act of 1940 (Advisers Act) the U.S. Securities and Exchange Commission (SEC) effectively states that the recipient must be a Registered Investment Advisor (RIA). RIAs can receive compensation based on the performance of their advice only under prescribed circumstances, and they cannot engage in excessive trading or profit from market activity resulting in their advice to clients. In addition, they must act in the best interest of their clients at all times and take into consideration each client’s financial position and sophistication.
Growing concerns that investors could potentially lose access to valuable research led the SEC to issue three related no-action letters in October 2017. The letters are intended to provide a path for market participants to comply with the research requirements of MiFID II in a manner consistent with US federal securities laws:
- No-action relief to SIFMA
- No-action relief to ICI
- No-action relief to SIFMA AMG
This relief is only temporary, permitting broker-dealers to receive payments in cash or through MiFID-governed RPAs from “MiFID-affected clients”, without being considered an investment adviser, for a period of 30 months from the MiFID II implementation date of January 3, 2018. A larger controversy now exists in interpreting what is captured under the term “MiFID affected?”.
Additional relief was provided under the Division of Investment Management, permitting investment advisors to continue to aggregate client orders for the buying and selling of securities, where clients may pay different amounts for research due to MiFID II requirements, but all clients will continue to receive the same average price for the security and execution costs.
From the Division of Trading and Markets, relief was provided to allow money managers to operate within the safe harbour of 28 (e), provided the money manager makes payments for research alongside payments for execution to an executing broker-dealer, using client assets through an RPA that conforms to the requirements for RPAs, as explained within the MiFID II guidelines.
US buy and sell-side firms have adopted different approaches to this issue:
- Bundled or Full-Service trading – We believe around a quarter of US equity trades are typically executed at a full-service rate. A full-service trade is executed at a “bundled” rate that includes compensation for the execution of the specific trade and a contribution towards the research services provided to the asset manager by the executing broker. By getting paid for their research product alongside a trade, brokers avoid being in breach of any SEC guidelines. MiFID II regulations that went live on Jan 3, 2018 prevent European asset managers from engaging in this form of bundled trading;
- Commission Sharing Agreement (CSA) – We believe about 40% of all US equity trades are executed within a CSA framework. A CSA ensures that both buy-side and sell-side firms are explicitly unbundling every trade into execution and research. CSAs provide greater transparency than bundled trading and additionally allow asset managers to control how much they pay each research provider for research services. Following a formal research evaluation, or broker vote process, many buy-side firms often choose to allocate funds from their CSA program to the executing broker for its research product. In this scenario, the asset manager instructs the CSA administrator to retain an allocation from the CSA pool which is directed to that broker’s research desk. This method allows payment for research, without the broker needing to be registered as an Investment Advisor;
- Registered Investment Advisor – Some sell-side firms have chosen to register as an RIA with the SEC. Bank of America Merrill Lynch was the first larger name to take this approach, filing just before the regulator issued the no-action letters. It is possible that others will follow suit to ensure there is no issue when accepting hard dollar payments for research, particularly after the 30-month period when the no-action relief expires. Registering as an RIA means the broker must explicitly separate its execution and research businesses into two separate legal entities with very separate P&Ls.
This issue affects both the buy and the sell-side. Given the complexity of paying for US research out of P&L, CSA adoption has continued to grow in the US. Whichever strategy sell-side firms adopt, US brokers are focused on servicing their European clients and ensuring they can get paid for their product as efficiently as possible.