The aggressive UK Financial Conduct Authority (FCA) call for a ban on research commissions has generated heated reactions, even in the insular US market. There is skepticism that other European regulators support the FCA’s position, and the regulatory battle lines are now moving to the continent. Independents are wary of the fallout from a ban.
Two weeks ago, the FCA stunned industry observers by releasing a discussion paper supporting an elimination of asset managers’ license to pay for research with client commissions. The FCA’s extreme position was precipitated by a review it conducted of current market practices and also by its view that the European Markets in Financial Instruments Directive (MiFID) reform was headed in the same direction. The FCA concluded that MiFID II would effectively ban research commissions and that this would be a net positive.
Not so fast
However, many are taking exception to the FCA’s interpretation of MiFID II. First, there is a view that the inducements provision in MiFID II was originally intended to address inducements given to retail financial advisors as incentives to recommend specific securities or funds. The argument is that extending the inducements language to reform the institutional market was not contemplated in the original regulation.
Further, the market regulators in France and Germany are rumored to be uncomfortable with the extensive reform embodied in the FCA’s position. We spoke with sources in Paris who attended a conference sponsored by FinFees, a French consulting firm, AlphaValue, an independent research firm, and ITG on June 24th, during which the French regulators presented their perspective.
At the conference, the Autorité des Marchés Financiers (AMF) indicated that it favored more commission transparency, and has been a strong supporter of commission sharing arrangements (CSAs). However, the AMF seemed hesitant to adopt changes that would reduce the volume of research. It would be concerned with the impact of a ban on French asset manager profit margins, which remain depressed after the financial crisis. The AMF was also worried that smaller asset managers would be less able to afford research than larger managers, putting them at a competitive disadvantage.
It appears that the FCA has some lobbying to do with their regulatory colleagues, but then again, the arguments assembled in its discussion paper suggest that it was aware of continental concerns and has sought to address them.
US reactions
We have been surprised by reactions from US asset managers. A meeting we had last week with a mid-sized US asset manager opened with a thirty-minute discourse on the shortfalls of the FCA position. We were told that the head of US sales for a major bank fielded a dozen calls from US managers in the first few days after the FCA announcement. US asset managers are paying attention, and not liking what they are seeing.
Not that we expected any movement from the US Securities and Exchange Commission (SEC) on this issue anyway. The likelihood of US reform is so negligible as to be non-existent. A repeal of Section 28(e) of the Exchange Act would take an act of Congress. This would require a groundswell of negative sentiment to overcome the political influence wielded by the banks and asset managers.
Independent worries
Independent research providers are tantalized by the land of milk and honey envisioned by the FCA, where all research is explicitly priced and there is a more level playing field with the investment banks. However, independents worry they will expire in the wilderness between here and the Promised Land. We have already seen independents lose market share to banks when commissions fell 40% after the financial crisis, as asset managers shifted commissions to protect their largest relationships.
Banks are able to cross-subsidize research with their corporate finance business, giving them more staying power than independents during the financial dislocations following a ban. Independents are concerned that the exemption of broadly distributed research from the inducements language will translate into a free pass for bank research.
Next steps
The deadline for comments on the MiFID II draft language is August 1st and there is expected to be a deluge of responses. Reportedly the volume of responses is a factor in determining any revisions to the language. A subsequent consultation paper is expected to be published between December 2014 and March 2015, which will contain the next version of inducements rules. EU Member States are required to adopt MiFID II provisions by June 2016 and the rules would take effect January 2017.
In the meantime, banks are said to be aggressively lobbying European regulators to water down the inducements provision, and to oppose the FCA position.
Our take
We had assumed that the draft MiFID II language reflected a consensus among European regulators, but that does not appear to be the case. We’ve also been surprised by the depth of US reaction. It appears there will be a large and highly mobilized global backlash to the FCA position.
The outcome will now be a function of European politicking. The FCA decided that its best course would be to lay its cards on the table with a thorough 59-page paper outlining its views. The fact that it went public suggests that it may not have a strong hand to play in negotiations with its European counterparts. Perhaps the FCA hoped for a groundswell of public support. Whatever the goal, the FCA’s paper has had the perverse effect of galvanizing industry opposition.
The FCA bombshell might at first seem a political miscalculation, serving to frighten both friends and foes to reform. In reality, the FCA is in a no-lose position. The firestorm has ignited deep industry debate, even on this side of the pond. Even if MiFID II does not ultimately ban research commissions, it will have sensitized the industry and the FCA’s regulatory colleagues to the issues surrounding research commissions. At a minimum, the net result will be a far tighter regulatory regime than existed a year ago.