European reforms to equity commissions are creating turmoil for both producers and consumers of equity research. Although an outright ban on research commissions is looking less likely, the regulators are signaling their intent to pressure for more commission transparency.
To ban or not to ban
If the current MiFID II language stands, there will be ban on using client commissions to pay for any research of value. The UK Financial Conduct Authority (FCA) publicly supports a ban on research commissions (and is rumored to have drafted the MiFID language imposing a ban.)
However, opposition to a ban is widespread, and regulators are taking note. Also, we understand from reliable sources that French and German regulators are uncomfortable with a ban, and they have the power to outvote the UK on the final language.
Movement toward a compromise
Lobbyists who are speaking with the regulators sense that they are looking for a compromise position that enhances commission transparency but stops short of a ban. The FCA is rumored to be reaching out through the International Organization of Securities Commissions (IOSCO) to enlist the US Securities and Exchange Commission (SEC) and Asian regulators to reform research commissions.
While the SEC cannot ban research commissions without an act of Congress, it has broad scope in how it chooses to regulate commissions. The FCA can’t persuade the SEC to ban research commission, but it might be able to gain agreement on a compromise position.
Will the ban threat just disappear?
So what might be a compromise position? One possibility is that the offending MiFID II language is simply deleted, as an influential advisory group has recommended.
There is much pushback, even from trade groups representing independent research providers, on whether research should be considered an “inducement”, as framed in the draft MiFID II language. However, the UK regulators have framed all their regulation of commissions, including the latest rules, in the context of regulating inducements. [See the FCA’s Conduct of Business Sourcebook (COBS) section 11.6.] The UK provides ample precedent for MiFID II regulation of research commissions under the rubric of inducements.
More likely, the European regulators will move closer to the FCA’s current commission regulation, which imposes more transparency while stopping short of a ban. This is exactly what happened in 2006 with MiFID I. The UK regulators had just tightened their rules for “eligible research” (now tightened further) and imposed a commission transparency regime. Although MiFID had no analogous language, MiFID’s “best execution” requirements were construed to support the use of Commission Sharing Agreements (CSAs) to reduce the number of trading counterparties and apportion commission payments to research.
In its most recent rules which took effect in June, the FCA: 1) banned the payment for corporate access with client commissions, 2) required asset managers to place a value on bundled research from investment banks; and 3) prohibited commission payment for research which is not used.
The FCA made it clear that it is looking for asset managers to set explicit budgets for research, so that research payments do not fluctuate with commission volumes. Woe to the asset manager whose research payments go up just because trading increases.
A boost for CSAs?
One area for compromise might be Commission Sharing Agreements (CSAs) which separate bundled commission rates into execution and research components. By themselves, CSAs do not do what the FCA is now demanding. They do not impose budgets on research nor do they place a value on the research received. However, it would be extremely difficult if not impossible to budget research without them. In other words, they are a necessary but not sufficient condition for conforming to the new FCA guidelines.
While CSAs have been adopted by many asset managers, a large portion of equity commissions still go through bundled commissions. In the UK, perhaps 40-50% of commission volumes flow through CSAs. In the US, according to a survey we conducted earlier this year, 35-40% of equity commissions go through CSAs. This is a sure sign to regulators that the industry is not wholly on board with greater transparency.
It would not be surprising then if MiFID II ended up supporting greater use of CSAs. Whether or not CSAs are explicitly mandated, regulators are likely to use CSAs as a metric for measuring industry compliance with greater transparency.
Across the Pond
The industry has taken great comfort from the fact that a ban on research commissions in the US would take an act of Congress. Plus the SEC seems to have little interest or appetite for the topic of commission transparency.
However, the SEC doesn’t have to stir itself too much to make an impact on commission transparency in the U.S. In 2010 it issued a no-action letter saying that investment banks could accept commission payments through a CSA (or a Client Commission Arrangement as they are called in the US) without impairing their ability conduct principal transactions. Nevertheless, investment banks continue to balk at taking payments for their own proprietary research through CSAs. It would not take much effort on the SEC’s part to correct this.
At this point the future regulatory landscape is still uncertain, but there is no mistaking the direction regulators are headed and the seriousness of their intent. While an outright ban on paying for research with client commissions is looking increasingly unlikely, European regulators seem disposed to use MiFID II to prod the industry for more commission transparency. CSAs are well positioned to benefit.
We suspect that European regulators will go even further toward replicating the current FCA rules, whether or not explicit language is incorporated in the MiFID II rules. European regulators may not have the FCA’s detailed understanding of research commissions, but they can grasp the concept that research payments should not increase just because trading volumes increase. It is even possible that the SEC might make a token effort in the interest of regulatory harmony.
While the industry might breathe a sigh of relief at averting a ban on research commissions, the prospect of broad regulatory acceptance of the new FCA regime will be more than sufficient to ensure major changes in the research landscape. More on that later.