Will the UK Ban Payment for Research with Client Commissions?

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Visiting London last week, it was clear how white-hot the topic of commission payments for research has become.  The CFA Society of the UK released a poll of its members in which two-thirds of respondents believe that buy side firms will eventually be forced to stop paying for sell side research using client money.  Meanwhile the Financial Times continues to bang the drum, with a guest editorial from a former Lex editor arguing in favor of abolishing the payment for research with client commissions.

The predecessor to the UK Financial Conduct Authority started the brouhaha at the end of last year by reporting that many asset managers were squandering their client’s commissions on research in an undisciplined fashion and requiring fund CEO’s to certify that they were taking appropriate steps to spend client commissions responsibly.  The FCA promised to revisit the issue.

Meanwhile, the Financial Times has been pursuing the topic relentlessly, forcing the trade association for UK asset managers, the Investment Management Association, to form a blue ribbon panel to study the topic and make recommendations scheduled for publication next month.  The head of the IMA wrote an opinion piece in the FT in which he envisioned an ‘efficient market’ for research: “It would be one where services were bought directly by managers. Brokers would set cash prices and managers would pay directly only where they believed the service and cost represented value. Payments met by clients would be accounted for directly.”

CFA UK, whose head is a member of the IMA’s review panel, released a survey of its members with 350 investment professionals responding.  Of those, nearly 60 per cent said the current research model does not best serve the investor.  Only a little more than a third of respondents (37 per cent) think that investment companies should continue paying for research from the banks using the client’s money in the form of commissions.  A majority (53 per cent) think investment companies should pay for bank research using their own balance sheets. Two-thirds of respondents believe that investment companies will eventually be forced to stop paying for bank research using client money.

A couple of weeks ago, a former FT editor, Vince Heaney, joined the fray by extolling the virtues of eliminating the payment of research with client commissions: “There is an opportunity between the regulator, the fund management industry and the pressures of a harsher market reality to create a more efficient system of valuing and pricing research that is more closely aligned to end investors’ interests.”

Heaney, who has been working with EuroIRP, the trade association for European independent research providers, had authored a report questioning whether corporate access could be legitimately paid by client commissions under UK standards, which became part of the FCA’s subsequent review of commission payments.

In his FT opinion piece, Heaney acknowledged that abolishing the ability to pay for research with commissions would harm independent research providers: “For smaller independents this could be far more damaging than for large investment banks, which are better able to absorb a decline in revenue in one area of their business.”

A recent poll of fund managers by COOConnect, a London-based peer group network of fund Chief Operating Officers, found that only one manager in three had taken any of the measures required to comply with the FCA demands and the remaining two thirds had taken no steps at all, suggesting that the UK fund industry is highly vulnerable to further FCA sanctions.

Many of those we spoke with last week believe that payments for research with client commissions will be abolished.  The passion and immediacy of the topic was startling to someone coming from the U.S. where the regulators are somnolent on the matter.

This raises the question of how far the UK regulators will go in breaking new ground.  Would they demand UK asset managers to pay for research out their own pockets when no other domiciles require it?  This risks industry flight to other domiciles.

UK regulators may be able to forge a European consensus on the topic.  Regulators in France, Germany and other European domiciles have been following the UK lead on unbundling research commissions from execution.  Italy and Spain already discourage the payment of research with client commissions.  Even so, what would stop UK asset managers from shifting their research to New York or Hong Kong or other domiciles where commission payments are allowed?

While we are betting that the FCA will pull back from an outright ban, it is clear that scrutiny of client commissions will be intense.  The two-thirds of fund managers that aren’t paying attention according to the COOConnect poll will have to become much more proactive in their management of research payments.  Further, it is likely that the old regime of increasing research payments as commissions rise will be under pressure, putting a cap to research spending even as markets recover.

And it is possible that the furor in the UK might stimulate some activity across the pond.  You never know.  In any case, we’ll be fascinated to see how it all plays out in the coming months.

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