MIFID II: THE IMPACT OF UNBUNDLING.

By Ivy Schmerken, Editorial Director at FlexTrade.

Even though the final Markets in Financial Instruments Directive (MiFID) II rules are still evolving, buy- and sellside firms in Europe are bracing for reforms that could sever the link between research payments and dealing commissions. New rules from the European Union are going to transform the way that asset managers pay for investment research and report the value of research to their end clients. The onus is on the buyside to control the research costs. For example, the buyside is required to assign a price to each piece of research and to pre-determine a research budget on an annual basis.

“In its final advice to the EC, The European Securities and Markets Authority (ESMA) recommended that the investment firm must pay for the research directly with their own funds, or pay for such research from a designated research payment account funded by specific charges to its clients,” wrote attorneys at Sidley Austin in the law firm’s May 16 update to clients.

As for the sellside, the regulatory overhaul has the potential to disrupt global research models. Rather than purchase research services with brokerage commissions, MiFID II will allow investment managers to pay for research in one of two ways. The EC’s Delegated Directive, published on April 7, states: Investment firms can fund research from their own accounts and pay from their own P&L with hard currency. Alternatively they can set up a so-called Research Payment Account (RPA), a new concept where the RPA must be funded with a specific research charge to the client. The asset manager must create a research budget for the year ahead.

CSAs: Are they allowed?

One of the unanswered questions has been the fate of Commission Sharing Arrangements (CSAs), a type of research payment mechanism that allows the buyside to allocate commissions to brokers and independent providers, while they are trading through execution-only brokers. CSAs are widely used in Europe and the US.

There was a leak of MiFID’s Delegated Acts in December 2015 which was, “encouraging because it suggested that there was an opening for commissions to be used as a currency for research,” said Chris Tiscornia, president and CEO of Westminster Research, a provider of research and commission management services.

Experts are of the opinion that buyside firms will have a choice of utilising existing CSAs, with the client’s permission, to fund the RPAs.

Will RPAs add complexity?

Brad Bailey, research director at Celent’s Securities & Investments practice, said, “The CSA became the tool for paying brokers and how you allocated [commissions] to the brokers, but the RPA is a much more complicated tool. You can’t just manage the process of paying other brokers. You have to value the research as well as manage the clients.” With the RPA, the buyside must predetermine the research budget and have a means of managing the dollar allocation to brokers.

“The end result could be potentially higher costs or greater complexity and access not to the same research,” Bailey cautioned.

Will asset management raise their fees?

“The largest asset managers will most likely pay for research out of their own pockets”, said Andrew Upward, head of market structure at Weeden & Co, an institutional broker in Greenwich, Connecticut. MiFID II also allows investment managers to raise their fees to recoup the cost of their research budget.

If firms are charging 50 basis points, and tell clients the fee is increasing by a handful of basis points, clients could go elsewhere, cautioned Upward. He contends that managers won’t be able to raise fees; asset managers will end up “eating” the higher costs. But it’s likely that if investment firms decide to pay out of pocket, buyside firms will become more selective about purchasing research.While larger asset managers have the scale to absorb the research costs without raising their fees, market participants have raised concerns about the impact of such rules on smaller asset managers.

Furthermore, the buyside values corporate access – a service to the buyside where the sellside sets up meetings with management teams and also offers invitations to conferences. With these changes it’s possible that the price of corporate access could actually go up.

The devil is in the details

Upon request, investment managers are required to provide clients with the budgeted amount of research, a summary of providers paid, services consumed, amounts paid, benefits received and totals spent in comparison to the budget. At the outset, they must tell the client what their overall research budget will be for the year.

Part of the ongoing debate is over whether the reporting to clients has to be at the strategy, portfolio, or account level. “The more granular the reporting becomes, the more cumbersome and costly it tends to be,” said Tiscornia, who adds that there is a concern that some managers will “throw their hands up” and decide to pay with their own funds.

On the upside

Despite some of the operational costs and complexity entailed with transitioning to RPAs, MiFID II is going to give investors more visibility into their research costs. “It mandates transparency for any fund that wants to use client’s assets to pay for research. Ultimately that’s better for the end client and is a good thing,” maintains Upward.

Since MiFID is a directive and not a regulation, there can be differences in the interpretation by national regulators. Some US fund managers with European sub-managers or affiliates could conceivably have to comply with varying regulations on usage of dealing commissions.

Some US investment firms are said to be looking at adopting a global standard for dealing with research payments rather than cope with multiple rules. Instead of having to comply with different standards and multiple modes of operation, large investment firms may decide to simply adopt the tougher European standard.

Fixed Income

European regulators are said to be speaking with the industry on how it intends to unbundle fixed income research. How the final rules will shake out remains to be seen. As with all regulations, there will be unintended consequences from MiFID II’s revamp of research payments. What can be said with certainty is that regulators want to see a real separation of research payments from the volume and value of trading. n

This article is an abstract from a full-length white paper also entitled, “MiFID II: The Impact of Unbundling” by Ivy Schmerken. A copy may be downloaded at www.flextrade.com/unbundling.

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