This is the first article of a two part series on ‘the Swedish Model’, a complete unbundling of research payments from execution. In this article we will look at the origins of the Swedish Model.
A handful of Swedish asset managers have been on the bleeding edge of embracing a full unbundling of research payments from execution. The so-called ‘Swedish Model’, which separates research payments completely from commissions, is presenting challenges for investment banks in London and the U.S.
The Swedish financial markets regulator, Finansinspektionen (FI), sent a letter to Swedish fund management companies and investment firms in May 2014 providing its interpretation of the rules relating to transaction costs and research in the UCITS level 2 Directive (UCITS IV), the EU rules that govern collective investments such as mutual funds. Prior to this, it had been unclear whether commission sharing agreements (CSAs) could be utilized under Swedish regulation.
The FI said that research payments included in execution costs are an inducement and therefore in order to know – and prove – that clients get good value for their money, fund managers would have to know how much they are paying for research.
The FI also stressed the importance of unbundling costs for research from costs for executing orders, in order to comply both with the regulation on inducement and on best execution.
Guidance on unbundling
The letter stipulated that research costs must be distinct from transaction costs: “It is important that the management company separate the cost of research from transaction costs. The potential to burden shareholders with costs other than just the transaction costs is limited.”
Asset managers should not choose trading counterparties on the basis of their proprietary research: “In the evaluation and selection of counterparties to achieve the best possible result for portfolio transactions, the management company may not take into account the other party’s research capabilities, but only the capacity to perform the transaction.”
The FI said that it was permissible to charge research expenses to shareholders provided, among other things, the research cost is separately reported.
“Under certain conditions, it is possible for a fund to be charged for research costs… however, in each case, it must be determined whether the costs meet the provisions… Such an assessment should, in addition to the requirements [separating research costs from transaction costs], ensure that:
- a continuous, objective and documented evaluation of selected research partners takes place;
- the usefulness of the research corresponds to the cost;
- the research costs charged to the shareholders relate to such things covered by the Fund’s investment policy;
- the cost of research is separated and not added together with the cost of execution of orders; and
- the cost of research be reported as it occurs.”
The letter did not explicitly require budgeting, but the requirement of “a continuous, objective and documented evaluation of selected research partners” and the necessity that the usefulness of research correspond to the cost point strongly in that direction.
The same month that the FI sent its letter, the European Securities and Markets Authority (ESMA) released the first draft of the new Markets in Financial Instruments Directive (MiFID II) regulations, which banned the use of client commissions to pay for any research of value.
A handful of large Swedish asset managers concluded that a complete unbundling of the costs for research and execution would be the best way of complying with current and future regulation, rather than implementing CSAs. These managers have moved to a hard dollar payment regime, which has been referred to as “the Swedish Model”.
The Swedish Model conforms to the draft language of MiFID II which requires separate Research Payment Accounts which assess research-related fees to clients which are then used for hard dollar payments for research.
Not all Swedish asset managers have adopted the Swedish Model. According to Helene Wall, General Counsel of the Swedish Investment Fund Association (SIFA), a working group was formed last year to determine how FI’s requirements could be handled in practice.
The SIFA conclusion was that the FI requirements could be handled in different ways, the Swedish Model being one approach.
According to Erik Lindholm, a Deputy Director at the FI, the May 2014 letter does not preclude the use of CSAs in the context of UCITS IV. He, like all other European regulators, is waiting for the final MiFID II language to be released, which, depending on how it is worded, could be more problematic for the use of CSAs.
His view, like many European asset managers we have spoken with, is that the regulatory direction of travel is toward more unbundling of research payments from execution.
The next article will examine the impact of the Swedish Model on other institutions and its implications for MiFID II.