Global asset managers are discovering that the new MiFID II research unbundling rules conflict with US regulatory practice in a number of areas. One such issue is how the EU, under pending MiFID II rules, and US regulation handles cross subsidization, a practice where some clients’ accounts are effectively charged for the research used on behalf of other customers. The following is an excerpt from Integrity’s recently released 150 page study called MiFID II Research Solution Providers that addresses this and a wide range of related topics.
The new MiFID II rules pertaining to research require asset managers to develop written policies which outline how they will allocate research costs fairly across client portfolios:
“…investment firms shall establish all necessary elements in a written policy and provide it to their clients. It shall also address the extent to which research purchased through the research payment account may benefit clients’ portfolios, including, where relevant, by taking into account investment strategies applicable to various types of portfolios, and the approach the firm will take to allocate such costs fairly to the various clients’ portfolios.” [bold added]
Under current bundled commission practices, a fund or account that is more actively traded may generate more commission payments for research than a less-actively traded account, even though the research demands may be equivalent between the two. The fund with the higher turnover is effectively subsidizing the research consumption of the less-actively traded fund.
European asset managers lobbied hard to get regulators to accept strategy-level budgeting in order to mitigate the cross-subsidization problem for those funds aggregated under a common strategy. If funds are aggregated by a common strategy then less-actively traded funds which share an investment strategy with more actively traded funds might benefit from the higher research payments generated.
Both the UK regulators and French regulators have condoned strategy-level budgeting in their consultation papers.
As Mike Carrodus of Substantive Research noted in a commentary, issues associated with cross-subsidization could be sufficiently vexing to European asset managers to cause them to opt out of the research payment account regime by paying for research from their own P&L. However, the more likely scenario might be a hybrid approach, where asset managers use commissions to fund the majority of research, and pay from their wallets for research deemed to be cross-subsidized across strategies.
Asset managers operating under US regulations do not have to contend with cross-subsidization issues, other than disclosing that it occurs. The US Securities and Exchange Commission has condoned the practice by adopting specific disclosure requirements regarding cross-subsidization for the Form ADV and Form N-1A.
For example, for the Form ADV, item 12A(1) of the firm brochure requirement requires an adviser to “disclose whether you use soft dollar benefits to service all of your clients’ accounts or only those that paid for the benefits,” and to disclose “whether you seek to allocate soft dollar benefits to client accounts proportionately to the soft dollar credits the accounts generate.”
As a result, US asset managers routinely disclose in the Part 2 brochures of the Form ADV that their soft dollar practices benefit some clients over others. For example, here is Blackrock Advisors’ disclosure:
“While research or brokerage services obtained in this manner [through soft dollars] can be used in servicing any or all of a BlackRock Investment Adviser’s client accounts, such products and services tend to disproportionately benefit one or more clients relative to others based on the amount of brokerage commissions paid, the nature of the research or brokerage products and services acquired and their relative use or value for particular accounts. For example, in some cases, the research or brokerage services that are paid through a client’s commissions might not be used in managing that client’s account. In addition, other BlackRock Clients can receive the benefit, including disproportionate benefits, of economies of scale or price discounts in connection with products and services provided as a result of transactions executed on behalf of a client account for which such products and services are also used.”
The SEC’s more relaxed attitude toward research cross-subsidization is one reason why the default US approach to research payments will be funding through client commissions. European investors investing in US product will have to accept US rules, which permit research cross-subsidization. Perhaps European investors would prefer the additional protections offered by MiFID II, but if they like the performance of Blackrock’s US products, they will have to do without.
Blackrock’s European operations, on the other hand, will have to abide by MiFID II rules, but most global asset managers will strive for maximum operational consistency. For European asset managers, strategy-level budgeting is flexible. Strategies can be defined in a variety of ways: by investment style, by market capitalization, by geography. As such, European asset managers are permitted to group funds and accounts in ways that minimize the amount of cross-subsidization across strategies (maximizing the amount of cross-subsidization within strategies).
Ultimately, it will depend on how much control asset owners exert. It is not clear that asset owners will fire an asset manager for using bundled research. Asset owners ultimately care about performance so unless there can be significant savings to asset owners from unbundling, it is unclear whether US asset managers which cross-subsidize, as permitted under US regulation, will be at a competitive disadvantage to European asset managers.
 European Commission Delegated Directive dated April 7, 2016, Article 13, section 8, page 28. https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2031-EN-F1-1.PDF
 AMF: page 28 of consultation paper http://www.amf-france.org/en_US/Publications/Consultations-publiques/Archives.html?docId=workspace%3A%2F%2FSpacesStore%2F15f91213-d77a-48d4-b2dc-e63806b708e4 FCA: Section 3.21, page 28 of CP 16/29; https://www.fca.org.uk/sites/default/files/cp16-29.pdf;
 Form ADV Part 2 Brochure filed 03/30/2016 by BLACKROCK ADVISORS, LLC (CRD# 106614 / SEC# 801-47710)
 ESMA in its October 2016 Q&A emphasized that strategy level budgeting required that “client portfolios have sufficiently similar mandates and investment objectives such that investment decisions relating to those portfolios are informed by the same research inputs.”