This article was originally published by Thomson Reuters on complinet.com on 1 April 2015.
The European Securities and Markets Authority (ESMA) and the Financial Conduct Authority (FCA) have been looking at how firms use dealing commission. That is, the charges (worth around £3 billion a year) paid by consumers when investment managers execute trades and acquire external research on their behalf. The FCA published a Discussion Paper (DP14/3) in July 2014 and issued a Feedback Statement in February 2015 (FS15/1).
ESMA has put forward a number of assertions in its final technical advice on research and inducements to the European Commission in December 2014.
- It has confirmed that, in its view, the current market practice where a broker agrees higher execution rates to enable the investment manager to receive higher value research falls within the scope of an inducement under the Markets in Financial Instruments Directive II (MiFID II) and therefore the Level 1 restriction applies.
- It holds the view that bespoke and valuable third party research does not fall within the "minor non-monetary benefits" exemption.
- It perceives a risk that, without the restriction, the investment manager's duty to act in the best interests of its clients will be impaired.
- It considers that there is a risk a firm may be influenced to direct order flow or churn client portfolios to gain access to more valuable research.
ESMA's proposed solution is to separate investment managers' payments for research from execution arrangements and outlines a model for how research can still be paid for by investment managers without constituting an inducement.
The FCA's feedback follows ESMA's final technical advice and ESMA's proposed two options for change. These proposals are strongly supported by the FCA.
The proposals are that the investment manager can purchase research:
- Directly out of its own resources (the manager can choose to reflect this in an increase to the firm's portfolio management or advice fees)
- Through a "research payment account", funded by specific charge to the client which would be agreed and disclosed up front with the client. This charge would be based on a research budget set by the manager and would not be linked to execution volumes or value.
Brokers providing both execution and research services to investment managers must identify a separate fee for the execution service, with research services charged for separately and not influenced by levels of payment received for execution. Any surplus must either be rebated to the relevant funds or offset against future research budgets.
Allocating the costs of research
Can the costs of research be allocated across several research payment accounts on a pro rata basis where more than one client portfolio benefits from the common use of that research by the manager? The FCA believes they can.
The FCA's response to ESMA's approach of clearly separating payment for research from execution arrangements is that it will remove the inducement risk and conflicts of interest for portfolio managers "that their execution behaviour and choice of brokers may be unduly influenced ".
The suggestion is that the portfolio managers have a standard written policy to govern use of research payment accounts, getting agreement from clients to upfront charges and setting out the firm's approach to allocating costs. The FCA perceives this as less burdensome on firms and transparent to clients and is encouraging the investment management sector to start considering how they may change their internal controls over the use of dealing commissions now, rather than waiting until 2017 when MiFID II will apply.
So should the sector be starting to consider also creating new standard documentation and processes to be entered into with clients and brokers?
In relation to Commission Sharing Arrangements (CSA), the Investment Association appears to be ahead of the game and is proposing to produce a new model CSA in response to the proposed mandatory use of CSAs between asset managers and investment banks.
ESMA's advice relates to any third-party research and is not limited to any particular type of MiFID instrument and applies equally to fixed income research.
FICC (fixed income, currency and commodities) research is, currently, usually provided without charge. However, it seems to be the regulator's position that the charge for this research is "embedded" in the bid/offer spreads quoted by brokers.
There are industry participants who are sceptical of this view, maintaining that prices are net and are a product of a variety of factors such as supply and demand or counterparty credit risk, for example.
There is a risk that clients will have to pay for research they currently receive free of charge, for no compensating improvement in price.
Will the decoupling of research from trading costs will mean a narrower bid/offer spread? The FCA envisage it will and that it will open up the market for providing research on the credit markets to firms other than brokers in the bond markets.
Will the new regime disadvantage some issuers? There is a view that there will be a narrowing of coverage as brokers focus research on where they know they will be paid and this may deny SMEs exposure they might otherwise receive.
Overall, there are sectors of the industry that believe the new regime will bring material changes to large sections of the fund management community and have a direct impact on the economics of their business models. Fund managers manage their clients' money and aim to deliver returns over time. They are well practiced in using and relying on the existing sources of information that enable them to deliver those returns.
This view holds that if MiFID II requires fund managers to either pay for the research information themselves, charge their clients or build the information systems in house, medium and small fund management houses may be driven to closure or merger, presenting less choice for investors.
Next steps
The European Commission is considering ESMA's final technical advice and it is likely it will put forward draft delegated acts later this year, to be adopted no later than January 2016. Member states will have to adopt the measures in domestic law and regulations by July 2016 and MiFID II will apply from 3 January 2017.
The FCA has stated a preference to implement any changes to the UK's current inducements and use of dealing commission rules in line with the final reforms under MiFID II. It has not ruled out that it may also need to consider the treatment of AIFMD and UCITS investment management practices under the new regime.