The SEC’s no-action letter on Mifid II expires on 3 July… but chaos now reigns after Congress threw a spanner in the works with a new bill to enforce a further six-month waiver on investment research payments. With less than a month to go, which way will the regulator jump – and how on earth can the buy-side prepare for such uncertainty?
Then…
The unbundling of trading and research enforced in 2018 by MiFID II forced almost all asset managers in Europe to pay for research in cash only – the direct opposite of the US regime, where the SEC requires research to be paid in trade commissions and specifically does not allow for research to be paid in cash. To solve this disconnect, the SEC originally issued a temporary no-action letter acting as a waiver that allowed European asset managers to pay US brokers directly for research. This letter was rolled over once, giving the markets cause to believe it would be an ongoing exemption. But in July last year, the SEC caused chaos in the markets by confirming that had no plans to roll the letter over for another year – meaning that European asset managers had to scramble to find alternate ways of accessing (or, worse, not accessing) US research.
A survey by Substantive Research in August 2022 noted serious concerns from the buy-side: notably that the lapse could severely disrupt the way European fund managers and US brokers do business with each other… putting at risk over US$100 million of annual research payments and decreasing competition in the research market.
Almost a year later, and with less than a month to go until the 3 July deadline, the situation has suddenly got a whole lot more complicated.
Now…
“This is the most unpredictable situation that I think we’ve seen since 2016,” says Mike Carrodus, CEO of Substantive Research, speaking to Best Execution. “We’ve got a situation where research gets valued differently in Europe and the US, which obviously has an effect on people’s processes. That creates issues because in Europe, asset managers ended up putting research budgets onto their P&L because they were scared of the conversation – they didn’t like the idea of asset owners asking why they were being charged for research, when they were already paying for getting the trades done.
“What ended up happening was that the European buy-side pretty much decided to just pay for the research themselves – so the problem went away, although it hit the bottom line of asset managers, which meant that research was then evaluated in a much more professional, forensic way in order to ensure value and optimise their research budgets.”
At the time, US brokers were genuinely concerned that they might not get paid for research, so up against the wire in 2017 the SEC issued their no-action letter enabling European asset managers to pay in cash. They said it was temporary, but they rolled it on its first expiration date, which lulled everyone into a false sense of security. But then in July 2022, the SEC launched a grenade into the market with the news that the letter would not be renewed – claiming that asset managers should by now have been able to come up with viable solutions to the problem.
Whose problem?
According to Carrodus, however, the buy-side have few solutions to offer. “They’re the ones with the money, and they’ve accepted that they need to pay for research,” he says. “So 99% have just gone – ‘OK, we’ve got the cash ready on 4 July, and if we can’t pay you then that’s your problem. But it’s actually quite a big problem, because we can’t read your research for free, so if we can’t pay you, we can’t read your work.’ I think the brokers are a bit shocked actually, because they thought it was everyone’s problem and that everyone would work together to come up with solutions.”
Of course, there are exceptions. Very large American asset managers who have big European operations are more likely to be looking at solutions that they can put in place, because they’re feeling the pressure from the SEC. But if an asset manager is based in Europe, headquartered in Europe, and with most of its operations in Europe, it’s likely to be less concerned.
On the broker side, despite their concerns (and their intense lobbying), the SEC is displaying limited sympathy. It has already offered a solution, which is that brokers can register as investor advisors – a category which is allowed to charge cash for research.
But it’s more complicated than that. While this might work for firms that have less well-developed sales and trading functions, for those that do, there is a compliance risk inherent in registering as an investment advisor – as well as new structures, new operations and new disciplines that need to be put in place. “The bigger you are and the bigger your sales and trading function is, the less you’re going to want to do that,” explained Carrodus.
There’s also another tail risk – if brokers register as investment advisors, then they can take cash from anywhere and anyone (relatively speaking), not just from European firms. Could they take cash for American firms for the same service, for example, and would this change research into an in-house cost for US asset managers as well? The SEC is unlikely to approve.
“It’s a case of who blinks first. There are a lot of brokers that are aghast at having to come up with more new solutions, and deal with yet more regulatory confusion,” says Carrodus. They’ve already been dealing with a lot of that over the last few years, so this is just another punch in the gut. You can see why the SEC doesn’t feel like it’s their job to fix all of this but at the same time, this was a problem that didn’t need to happen.”
Cat among the pigeons
But it doesn’t end there. The House Financial Services Committee (HFSC) of the US Congress in April 2023 introduced a new bill, sponsored by Rep. Pete Sessions (TX) to “to codify certain SEC no-action letters that exclude brokers and dealers compensated for certain research services from the definition of investment adviser”.
According to the HFSC, this would: “strengthen American capital markets by providing US broker-dealers relief from MiFID II regulation, preventing a reduction in investment research that would harm investment managers and the retail investor customers they serve.”
The bill proposes an additional six-month extension of the letter, along with a detailed study of the impact of its expiry. Although approved by the HFSC on 24 May, the bill has yet to be passed by the House or the Senate, following which (should it be approved), it still has to be signed by the President – meaning it is vanishingly unlikely to pass into law before the 3 July deadline.
“There is massive bipartisan support for the bill,” reveals Carrodus. “So it’s a ridiculous situation, really, Everyone is scrambling to get ready, but at the same time, wondering if they’ll get more time, or get a last-minute reprieve.”
With less than a month to go, the question is… what will the SEC do now?
“It’s no way to regulate a market,” frowns Carrodus. “And all of this just encourages the buy-side to do nothing.”
Across the pond
Rebundling is already firmly on the radar in Europe – including a 2020 consultation launched by the European Commission, along with propositions on rebundling included in the December 2022 legislative proposal to amend Mifid II that is currently undergoing Trilogue. In the UK, divergence post-Brexit has given rise to a further change in approach, with exemptions included in the Wholesale Markets Review and the strong likelihood of some rebundling language included in the ongoing Investment Research Review, announced as part of the Edinburgh Reforms in December 2022.
“But even if it happens, how will it be received?” asks Carrodus. “Who is going to be the first asset manager that picks up the phone to their end investor and says ‘you know what, we took that cost away from you in 2018, and now that you’re used to not paying, we’d like to put it back on again.’ I’m sceptical. I haven’t spoken to an asset manager who is prepared to do that.
“It’s too late because it’s commercial now, not regulatory. You can’t go back”
What next?
So what happens now, with the SEC and Congress at loggerheads?
“There is total uncertainty about what the next step is,” says Carrodus.
“I think the SEC will be under enormous pressure to listen to Congress and extend the waiver by at least six months, then review whether they need to discontinue or extend it. But even if it’s only extended by six months, that takes us to January which is a new calendar year, so at least then there will be new budgets, while more brokers will also have more time to register as investment advisors if needed.
“Over the long-term, I think we’ll see a mixture of people paying in Europe, paying for other parts of their research through registered investment advisors, and then just not using some brokers anymore. And those brokers are likely to have decided that European revenues just aren’t important enough to deal with the regulatory and financial hassle needed to accommodate those payments.”
©Markets Media Europe 2023
