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Magazine Issues » November 2015

MiFID II: Clear as mud

ConfusionThe European Commission has demanded that payments for research must be unbundled from execution payments – but as Nicholas Pratt discovers, nobody yet knows how it will be done.

A central part of the European Commission’s reform of Europe’s securities market is to make asset managers separate the payment for execution of orders from the payment for third-party research. The EC has been clear that this ‘unbundling’ must be carried out so that investors can see exactly what their fees are being used for. The problem is that the EC’s updated Markets in Financial Instruments Directive (MiFID II) has yet to clarify any final rules for how unbundling will be achieved. 

The prevarication is causing consternation among market participants.  “Where are we? We are nowhere,” says Juan Pablo Urrutia, managing director, general counsel at ITG, an independent execution and research broker. “We have zero visibility into the European Commission.”

It is not yet clear whether MiFID II will allow for fund research to be paid for through existing commission-sharing agreements (CSAs) or will demand that firms set up research payment accounts (RPAs), a concept introduced by the European Securities and Markets Authority (Esma) in December. 

Commission-sharing has been in place in the UK for some time. It allows dealing commission to be used for certain execution and research costs. For example, it could be agreed that 5 basis points (bps) of a 10bps dealing commission be set aside to pay for research from stated providers from time to time. 

As a provider of commission-sharing aggregation technologies, firms such as ITG are playing the waiting game ahead of Europe’s final decision on research unbundling.  “The problem is that without a decision on whether CSAs will remain or whether RPAs will be used, we do not know where the resources are meant to go and what we’re meant to build,” says Urrutia. 

Should the EC dismantle the current commission-sharing system and mandate the use of RPAs, it could take between 24 and 36 months to set up new systems, a scenario that would go way beyond the seemingly immovable MiFID II implementation deadline of January 2017. 

“Hopefully there will be at least one adult in the room, but I think the populism we saw during the European elections is waning and some pragmatism will be more evident,” says Urrutia. “I am 100% sure we will have some clarity in November but I don’t know if we will have 100% clarity.”

Consultant Investit has been working for more than three years on the issue of broker research by benchmarking the use of commissions for execution and research services and working with firms on research budget setting. “We benchmark research budgets against other firms to see if they are outliers,” says Clare Vincent-Silk, Investit managing director. “This gives a sense of proportion, but managers also need to understand if they are getting value for that amount. To support this, we go through their investment process and establish how they use research to support this and how many different sources they use. For example, how many phone calls do they make and how many articles do they read to support their decision-making?” 

She says analysis of research can help work out what an investment manager’s ideal budget would be. 

“A firm needs to state why it spends what is spends and pays what is pays on research,” says Vincent-Silk.

Of course, the brokers are not keen on this process. “They hate it. For a start, their commission spend most often goes down once managers start to see exactly how much they are spending.” 

Consequently it is possible that a number of brokers will struggle to stay in the game not only because their commissions are reducing, but because unbundling might lead to a greater use of independent research providers. 

According to Investit statistics, the average number of independent providers used has dropped 32% from 2012 to 2014; however this is in keeping with a general trend among managers to reduce their number of counterparties, which has fallen by 11%.  However, the amount spent on independent research providers as a percentage of total spend on research has increased from 5% in 2012 to 7.5% in 2014.

Although there is the likelihood that the unbundling of broker research will lead to a greater use of independents, there is also a risk that rule changes could actually lead to the funding for research being removed, says Peter Allen, chair of Euro IRP, the representative body for Europe’s independent research community. 

It is the classic case of regulations creating unintended consequences, says Allen. “All the regulators say that they like independent research and we have seen the market grow. But independent research depends on money being available to buy it, so anything that could diminish that pot of money is a concern. The regulators have to be very careful that they don’t destroy the funding mechanism and unintentionally wipe out the independent research market.” 

Independent researchersThe lack of clarity on MiFID II rules could also inhibit the speed of innovation and development for a number of new businesses that have launched recently in anticipation of complete unbundling of the research sector – for example, the likes of Research Pool, ERIC, Seed Alpha (where Peter Allen is chairman) and RSRCHXchange (see box). 

“I think [unbundling] is an impetus that will help,” says RSRCHXchange co-founder Jeremy Davies. “With unbundling, every firm is already reconsidering their research process and looking at what they are getting in terms of benefit and value.”

Unbundling makes a lot of business sense, which is not something you can usually say about regulations, says Davies. “After headcount, research is the second-largest line item for managers. And considering how much consternation there is over headcount and even real estate, managing research consumption is something that warrants much more attention.” 

Allen, of Euro IRP, suspects the prospect of commission-sharing agreements surviving in some form is more likely than it was a year ago, especially in light of a letter to the EC from the UK Treasury and the German and French Finance Ministries in late August. But the ruling on CSAs or RPAs will have to be resolved. “They must answer the question, ‘What are we trying to achieve?’ Once they work that out, I’m sure they will be able to craft a solution. It may well be that RPAs become enhanced CSAs. It took many years to get CSAs to work. To simply throw away the valuable plumbing would seem like a waste.”

Some firms are considering paying for research themselves rather than setting up RPAs, says Vincent-Silk. “It streamlines everything from a process perspective. The average number of CSAs used by firms has increased from 14 to 21 between 2013 and 2014. It removes the regulatory burden and makes a great marketing message for their clients.”

Others are sceptical. “Asset managers will never pay for research out of their own pocket so the question is whether it will be taken from the fund’s assets or will it be added to their fees,” says Urrutia. “There are some firms that are doing this for corporate access and you have to believe they either have or are considering upping their fees as a result.”

What is clear, says Allen, is that the world has changed in terms of higher standards when it comes to transparency and allocation of clients’ money to pay for research. “The huge question is over pricing the investment banking relationship, rather than just research. The era of ‘free’ research is ending.”

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