Visiting London last week, we heard a consensus of cautious optimism that the final MiFID II rules will allow client commissions to continue to pay for investment research. However, there has been no substantive news since draft rules were leaked nearly two months ago, so it is not clear whether the optimism is based on fact or hope. (An article published last week claiming that the UK has reversed its position on a research commission ban has been discounted.)
Worse, beleaguered market participants no longer expect relief from the crippling uncertainty this month, with most anticipating rules to be released next month at the earliest and possibly not until September.
We had the opportunity to speak with seventeen informed sources during our London visit, ranging from asset managers to commission managers at leading investment banks to independents to representatives of trade associations. Everyone is frustrated with the topic, but it remains top of mind.
Lobbying
Even at this late date, it appears that large asset managers and investment banks have not given up the attempt to sway the European Commission. There is broad agreement that the unit within the EC responsible for drafting the final language is not inclined to alter the prohibition that research payments “not be linked to the volume and/or value of transactions executed on behalf of the clients.” Therefore lobbying efforts are focusing on more senior EC officials and on politicians having influence over the EC.
There are various theories about how the recent electoral victory by the Conservatives and their potential exit from the EU might alter the equation. Most feel that the Conservatives would be more willing to help the financial community, and speculate that the UK Treasury would be more open to compromise than the Financial Conduct Authority (FCA) has been. Nevertheless, last week’s article in HFMWeek is viewed as a distortion by those who have read the original letter cited in the article.
Despite the Conservatives’ resurgence, Martin Wheatley is viewed as secure as head of the FCA. Although appointed by UK Treasury, the regulatory chief is relatively immune from political vagaries. His term as CEO began April 1, 2013 and there does not appear to be a specified term limit in the FCA’s corporate governance framework. A five year term would expire April 2018.
Asset managers
Asset managers are impatient to move forward, and some are taking action, but most are waiting for the final rules. We heard reports of various managers beginning to adopt more rigorous budgeting processes: setting concrete monetary budgets for investment research, assigning a priori values to broker votes and in some cases formulating P&L budgets for each investment team.
Large asset managers have mooted a preference to pay for research out their management fees if research commissions are banned but it is not clear that this will be the actual direction of travel. For one thing, the concession in the leaked draft rules which allows asset managers to simply notify clients of research charges has been well received as making ‘research fees’ much more workable.
Except for firms which are largely passive or have low equities allocations, most large asset managers pay sufficiently large amounts for external research to make a meaningful dent in their profitability. In theory paying out of their own pocket would reduce regulatory costs, but in practice asset managers have told us they would maintain their vote and other budgeting mechanisms to manage their research procurement.
Assessing research charges to clients, especially under a regulatory mandate, would be the cheaper path in the event of a research commission ban. However, the details remain devilish for most asset managers and few are willing to commit to that approach at this juncture.
Investment Banks
Asset managers report that the investment banks have been importuning them with a vengeance to ensure that they receive a consistent percentage of spending under any new regime. One large bank, reportedly UBS, floated a pricing regime but the fees involved were broadly seen as too aggressive.
Asset managers are resigned to receiving little pricing guidance from the banks on currently bundled research. Both banks and asset managers expect the current negotiated approach to continue, but with more levers to pull.
After a few iterations, it will become clearer what coverage of a sector or a geography is worth, or what economic or policy research is worth. While benchmarks such as our 2015 survey of independent research pricing provide guidance, the process will still be negotiated as many enterprise-wide services already are.
Regulation vs. Directive
Market participants are still uncertain whether the final rules will be issued as a directive, which will require regulators in each country to incorporate the rules in their local regulation, or as regulation which is universally applied. If the former, the rules will be part of MiFID and, if the latter, part of MiFIR.
Guidance as of January was that the intent was to make the rules part of MiFIR, meaning there would be no local interpretation in an attempt to preserve consistency across Europe. However, given the disparate views of the French and UK regulators, some speculate that the EC may compromise by issuing the rules as a directive.
In the event the final rules are issued as a directive, the local regulator is permitted to make the regulations tighter so long as the basic rules are observed. The FCA has told market participants that it does not intend to ‘gold plate’ the final rules. However, many believe that the FCA is only saying this because it believes the EC will adopt its hard line views.
Timeline
After the EC completes the rules, whether this month, next month or September, the next steps will depend in part on whether the rules are issued as regulation or a directive. If a directive, the expectation is that the FCA would release its technical language in December, giving asset manager twelve months to implement.
However, if the rules are issued as regulation, the European Securities and Markets Authority (ESMA), the European regulator whose members are the financial markets regulators in each of the 28 member states, will be responsible for the technical language. Market participants expect this would be released in the first quarter of 2016, giving asset managers around nine months to implement.
Our Take
Londoners are justly famous for their stiff upper lip in the face of privations, and they are enduring the current uncertainty around research payments with typical aplomb. Yet this raises the question whether the current optimism is a coping mechanism or based in reality. They have put faith in the power of lobbyists which to date have failed to avert a ban on research commissions. It is impossible for us to tell if this faith is well founded or not.
However, even the most optimistic believe unbundling is a forgone conclusion. The open question centers on whether research payment accounts (RPAs) can be funded by commissions as well as by research-related charges assessed to clients. For this reason, we can expect the RPA structure to become broadly adopted over time, as commission sharing agreements have done since 2006.
Further, nobody expects the FCA to relent in its implacable hostility to the current regime. Whether it takes the form of gold plating a directive or aggressive monitoring and enforcement, market participants expect the FCA will be hyper-vigilant in ensuring that asset managers treat research payments with the care that they exercise over their own costs.
Whether commissions are permitted to fund RPAs or not, the new reality will be very different world, with London as its epicenter.