The following is a guest article from Amrish Ganatra, CEO of Commcise Software Limited, a provider of commission management and research evaluation software which recently received a majority investment from Euronext.
With the SEC actively reviewing whether to allow its MIFID II orientated no-action letter to lapse, asset managers in the US and Europe are faced with some tough decisions.
Commcise has previously written about the SEC’s 2017 decision to issue temporary no-action assurances to broker-dealers that receive certain payments under MiFID II, in order to permit US brokers to comply with MiFID II’s unbundling requirements without triggering registration under the Investment Advisers Act. This relief is scheduled to end in July 2020, which is now a mere 14 months away.
On 28 March 2019, SEC chairman Jay Clayton told the regulator’s investor advisory committee that ‘some market solutions have developed that may make extending the no-action relief unnecessary’. One of the solutions highlighted by the SEC chairman was what is often referred to as the ‘MFS model’ (as it was pioneered by Boston-based MFS) or as the ‘Rebate model’. A number of asset managers, including firms like TIAA and Capital Group, have now adopted this model. Asset managers using the Rebate model have decided to harmonize their treatment of research across the globe and therefore have chosen to pay for research out of their own resources. Given the inherent conflict with the Advisors Act for US-based non-MIFID impacted assets, firms using this model have overcome the challenge by employing CSAs (Commission Sharing Agreements) to accrue research credits alongside a trade. They then periodically rebate the research element of such trading activity back to their end asset owners. These firms have found a solution that does not rely on the SEC’s no-action relief and therefore are not impacted if the SEC chooses to let the relief lapse.
Chairman Clayton also referred to asset managers creating Research Payment Accounts (RPAs) to budget and track research costs at the fund level, permitting the funds to continue to pay for research through soft dollars and reconciling those payments to ensure compliance with MiFID II.
Models to be explored
Speaking at a conference earlier in March, SEC Division of Investment Management director Dalia Blass gave examples of market solutions that demanded further exploration by the regulator. These included fund managers using reconciliation or reimbursement processes to deliver cost transparency while addressing compliance, and broker-dealers exploring or taking steps to offer research through a registered investment adviser. Blass added that the SEC was willing to engage with the industry, stating, “we are particularly interested in hearing about the emerging market-based solutions and how we can support them”.
What firms need to do right now is prepare for the end of the SEC’s no-action relief and determine which market solution is most workable for their business.
We have heard on the grapevine that a number of firms have explored the possibility of migrating their research business into separately registered advisory businesses and deemed this too complex to achieve. Bank of America, which moved its analysts into a Merrill Lynch unit that is a registered investment adviser, and five others have found a way. Perhaps more will follow suit in the future. Most asset managers aren’t expecting any immediate changes in this regard in the near term.
According to an Integrity Research article [link requires subscription], another market solution being considered is the use of dedicated cash accounts to settle the research portions of trades. US brokers are evaluating this approach as an alternative to converting their research units into RIAs provided the cash payments are not viewed as “special compensation” under the Investment Advisers Act.
For MIFID II impacted firms, an alternative approach may be that global research providers find a way to deliver their US product through a European subsidiary. This may circumvent the need to register as an Investment Advisor in the US. Once this research product is sold directly to an asset manager in Europe (paid for either by an RPA or by a hard dollar cheque) all that’s left is for the US and European entities to reconcile the fact that some product has been sold, which then becomes an internal transfer pricing conversation.
Divergence between US & Europe
A recent Integrity research article [link requires subscription] underlined the precedent for divergence between European and US regulatory strategy, noting that after UK regulators forced UK asset managers to reveal research costs in Level 2 Disclosures in 2006, the SEC chose to instead foster market solutions (i.e. CSAs) with a couple of no action letters.
Unfortunately, European regulators do not accept that firms can’t comply with both regulations. So if European asset managers want to continue using an RPA, they may need to start lobbying European regulators to allow an exemption for the US side of their business, or hope that one of the other market solutions becomes viable.
Managers can continue to pay independent research providers by cheque. It is also important to note that the SEC has no issue with firms using bundled commissions.
More than two thirds (70%) of the US asset managers that participated in a survey conducted by EvercoreISI in February 2019 said de facto unbundling would continue to grow through the active use of CSAs. Firms that want to embrace the spirit of MiFID II can use CSAs to show a separation between trading and how they value their research.
Regardless of the approach taken, accounting for research payments remains a source of considerable complexity – albeit a process that can be supported with new technologies that offer a robust accounting framework
Firms that embrace the spirit of MiFID II are best placed to accommodate any future market developments. The jury is out on whether a move to pay for research out of P&L is in the best interest of the end asset owner. A recent study conducted by Evercore ISI shows how fund performance has been impacted for firms who’ve chosen to pay for research out of their own resources. US asset managers currently seem to have the advantage over their European counterparts.