In a dramatic move, the UK Financial Conduct Authority (FCA) has called for sweeping reform of research commissions, eliminating the ability of asset managers to pay for research with client commissions. The aggressiveness of the UK regulator caught the industry off guard even though the FCA has strongly signaled its concerns since last October. The FCA’s position increases the likelihood that major reforms will be implemented in Europe through MiFID II.
The FCA released a 59-page discussion paper detailing the results of its recent thematic review of client commissions, which in large part has led to a hardening of its position. The paper, which is a must-read for anyone involved in the research industry irrespective of their domicile, articulates the regulator’s reasons for advocating major reform and its assessment of the impacts of reform. We will review the paper in this and subsequent articles.
From November 2013 to February 2014, the FCA conducted a thematic supervisory review of 30 firms including 17 investment managers and 13 brokers. The results were not positive. The FCA acknowledged that many of the investment firms had made improvements in their procurement of research since the FCA wrote a ‘Dear CEO’ letter to asset managers in November 2012 calling attention to shortcomings. However, the FCA found only two firms operating at the level the FCA expected, and these were the same two firms that the FCA had originally held out as models in 2012.
The FCA found that for 11 of the investment management firms, the amount paid for research remained linked to trading volumes because the firms did not have research budgets or caps on research spend. Even more blatantly, one large firm was using dealing commission to pay for market data services in full, contrary to guidelines established in 2006 and updated this past May.
The review also increased the FCA’s understanding of the current commission regime, and it did not like what it found. Because the majority of asset managers link research payments to trading volumes, the FCA was troubled by the fact that research payments fluctuated with the level of trading irrespective of the value of research. Worse, asset managers were often paying for research they did not want or use.
Many asset managers were not using Commission Sharing Agreements (CSAs) which help to separate execution from research. And while the FCA considers CSAs as current best practice, it recognized that CSAs have limitations in providing transparency and a competitive market.
The FCA also took a dim view of most broker vote practices since most broker votes do not directly assess the monetary value of the research received.
Call for reform
Both the UK Investment Management Association and the CFA Society UK suggested additional disclosure as a solution to the conflicts inherent in the current regime. The FCA dismisses disclosure as an effective remedy, in part because disclosure was the main impetus around the regime imposed by the FCA’s predecessor in 2006, and yet it was clear that the intended recipients of the disclosure, the clients of the asset managers, were not paying much attention to the disclosures.
Ultimately, the supervisory review has led the FCA to discount the value of incremental reform, preferring deeper structural change:
“Overall, we conclude that unbundling research from dealing commissions would be the most effective option to address the continued impact of the conflicts of interest created for investment managers by the use of a transaction cost to fund external research. We believe it would drive more efficient price formation and competition in the supply of research, removing the current opacity in the market.”
The FCA’s stance on reform is not just the result of its recent supervisory review, but also reflects the parallel progress of European reform through the Markets in Financial Instruments Directive (MiFID).
While the FCA has been focusing on commissions, the second generation of MiFID has been grinding slowly through Brussels. MiFID II will prevent portfolio managers from receiving any third party inducements, with a limited exception for ‘minor non-monetary benefits.’ Inducements include receiving research in return for client commissions, effectively banning research commissions. The proposed language is sufficiently strict to lead the FCA to conclude that an investment manager’s ability to receive research from brokers or other third parties in return for dealing commissions will be significantly restricted.
The FCA views MiFID II as a window of opportunity for European-wide reform of commissions. This has two benefits for the FCA. First, it would make UK reform less of an outlier if all of Europe were under the same regime. Second, it takes some of the industry heat off the FCA since reform would be coming from the EU not the UK.
The reality is that the FCA remains a bellwether for financial regulation in Europe, despite the UK’s diminished status within the EU. The FCA’s strong stance on reform increases the likelihood that MiFID II will institute commission reform.
Further, the FCA outlines in its discussion paper more thorough reform than is currently implied in the draft MiFID II language, and we suspect it will be lobbying its European regulatory colleagues for the most stringent interpretation.
Why the hard line?
Though gloved in velvet, we now know that the FCA has an iron fist on this issue. Like many in the industry, we were startled when FCA Chief Martin Wheatley passionately attacked research commissions last October. However, we reasoned—wrongly—that concerns for UK industry competitiveness would ultimately dissuade the regulator. After the FCA published the final rules in May of this year, the industry assumed that compliance with the new guidelines would forestall any more drastic measures.
What changed? Two factors hardened the FCA’s position. First was the thematic review, which convinced the FCA that no amount of regulatory reform could counteract the economic disincentives inherent in the current commission regime. Second is MiFID II, which is heading in a hardline direction. The FCA decided that rather than trying to steer the MiFID II toward a more moderate outcome, it would throw its weight behind making MiFID II the death knell for research commissions.
Because the FCA is linking reform to MiFID II, it is not proposing at this point to unilaterally implement a research commission ban in the UK. Its discussion paper is meant to elicit feedback which will inform its participation in the MiFID II process. The FCA requests comments on its position by October 10, 2014, and suggests that interested parties also submit comments to the regulatory bodies involved with the implementation of MiFID II.
The FCA expects the final MiFID II language to be finalized in late 2014 or early 2015. Any reform implemented under MiFID II would be implemented by 2017.
The FCA’s passionate commitment to commission reform will have major implications not only in Europe, but in the U.S. and Asia. The FCA will not only be lobbying its European regulatory counterparts as part of the MiFID II process, but also its other regulatory counterparts outside of Europe.
We deeply doubt that the U.S. Securities and Exchange Commission (SEC) will muster enthusiasm for the level of reform the FCA is advocating. In part this reflects the fact that U.S. reform would require an act of Congress.
Nevertheless, as the FCA points out, globally active investment managers may voluntarily move to adopt European standards which would have a knock on effect for international suppliers of execution and research services. At the very least, global managers would need the ability to implement European standards as they apply to European funds managed.
No one seeing the FCA’s recent success in banning commission payments for corporate access will dismiss the seriousness of its purpose, nor its potentially far-reaching impacts.