Research ‘unbundling’ under MiFID
The effects of MiFID on the financial markets will be profound and impact almost all aspects of how the markets are managed. The distribution and consumption of research is no exception to this, with the new framework that is being finalised under investor protection causing many sleepless nights to those firms who are attempting to interpret this into pragmatic infrastructure. This directly affects banks as research producers, and asset managers or pension funds as research consumers.
Complying with the MiFID regime will be the only way in which firms providing portfolio management or independent investment advice can receive third party research, unless the research is of “minor non-monetary benefit”. Given that the investor protection frameworks sit within the directive, EU countries will each transpose the framework into local law; with all the complications that individual interpretations will bring.
Whilst the article here does not allow the space to examine every aspect, we highlight below some key elements and related challenges as a focus for discussion.
What constitutes research?
Whilst the question may appear basic, the reality is that there are several different lines being drawn here that will affect what research can be received and how it should be paid for.
One example of how the local transposition of the Directive will have variable outcomes can be seen within the definition of research. In the UK the FCA takes the view in a recently released consultation paper that, “Aside from research, no other material third party non monetary benefits can be received by portfolio managers and independent investment advisors under MiFID II in relation to these services”. On the other hand, the AMF appears to offer some flexibility within their recently released consultation paper, where they highlight the area of corporate access and suggest that the provider and portfolio manager need “to further refine the definition of this concept and systematically review it in the light of the criteria defining research”.
There is a set of currently distributed materials that will not be subject to the research charges as they will be defined as being of minor non-monetary benefit. Recital 29 says: “…non-substantive material or services consisting of short term market commentary on the latest economic statistics... …provided by a third party and contains only a brief summary of its own opinion on such information that is not substantiated nor includes any substantive analysis such as where they simply reiterate a view based on an existing recommendation or substantive research material or services, can be deemed to be information relating to a financial instrument or investment service of a scale and nature such so that it constitutes an acceptable minor non-monetary benefit”.
One interesting aspect of control that firms should be considering is that they have a duty to decide the category of what they are receiving from research providers and cannot simply rely on a research producer’s tagging. As the FCA puts in their consultation paper, “…This does not depend on the label attached to such material, but requires a consideration of the substance of its content. It is for the receiving firm to make their own assessment, and if material does appear to be substantive, value added research, and so is not minor in nature and scale, a firm will need to either pay for it under the new research requirements or not accept it.”
Equity vs Fixed Income
The MiFID regime applies to any MiFID financial instruments and so the effects of this regime will impact equities, fixed income and wider asset classes. Essentially for this area there are two broad approaches to dealing with the new commercial and compliance realities.
For equities there are established methods that revolve around the use of a Commission Sharing Agreement (CSA), especially in the UK – however these vary significantly across the EU, where for many market participants this entire approach will be novel. As we discuss later, the CSA structure will be permitted in the broader sense, although the management of the client’s funds changes dramatically.
Fixed income is greenfield – this community is not used to paying for research in the same way as equity and have traditionally benefited from receiving a wealth of free research. Whilst the structural approach to paying for research may therefore appear more straightforward, the reality is that the underlying fund commercials do not generally account for purchasing of research to the degree that will have to become the norm.
The new regime is very specific and limits firms to two choices as to how to pay for the research they receive. They may pay directly from their own resources, increasing their cost of doing business, or they may pay for research from a client-funded Research Payment Account (RPA). The management of the RPA is strictly defined and must be:
- Controlled directly by IM,
- Funded by explicit client charges
- Managed against a pre-agreed budget
- Regularly assessed against robust quality criteria measuring the value of the research received
- Managed so that the payments are not linked in any way to the volume of transactions
As the Delegated Directive sets out in Recital 27: “The research payment account should only be funded by a specific research charge to the client which should only be based on a research budget set by the investment firm and not linked to the volume and/or value of transactions executed on behalf of clients”.
Collecting research charges from investors
In one sense the regime allows for a number of collection methods, including direct payment, regular payments or collection via an aligned charge at the time of execution. However, there are significant changes to the existing CSA structure which will require a change in approach:
- Any research charge must be identified and transparent
- Funds must be transferred into an RPA, at time of trade
- The Investment Manager (IM) must have direct control over that RPA
Establishing a research budget
In parallel to establishing the methodologies for collecting the relevant client funds to pay for research, the firm is required to establish a research budget, which will define the amount of collected client funds. This budget must be “…based on a reasonable assessment of the need for third party research…’ (Para. 6 Article 13) and on the capacity of the research to contribute to better investment decisions. Firms are required to maintain a record of the value of any purchased research so that they are able to demonstrate to investors this value regarding their investment. There should be an ex-ante determination of value as well as an ex-post regular process of assessment of the quality of the research bought. The research budget should be built in such a way that its costs are allocated fairly to the different types of client portfolio and the cost implications to clients must be contractually agreed with clients ahead of time.
According to the AMF, the research budget is therefore “an ex ante estimate of forecast expenditure for research costs that can be charged to portfolios under management”, and “The overall budget must be sufficiently granular to be able to be pre-apportioned by portfolio”.
Building the budget can be established either as a ‘top-down’ or ‘bottom-up’ approach. The top-down approach as defined by the AMF is “establish an overall budget based on the investment firm’s estimated research requirement and apportion it by portfolio using a predefined allocation formula”. Whilst the bottom-up approach is to, “establish a budget by portfolio or type of portfolio based on the estimated research requirement for each portfolio or type of portfolio, in order to enable decision-making thereof, the sum of which will constitute the overall budget”.
In operating the budget, a major consideration is how client funds are looked after by the firm. For instance, if there is a substantial surplus at the end of the budget period, the firm is required to return those funds to the investors. If there is a shortfall in the budget compared to the actual costs being incurred, the firm must explicitly seek agreement from the investors prior to additional budget being added.
Conclusion: challenges are manifold
The way in which research distribution and consumption is currently managed will change dramatically in just over a year’s time. For the UK this will see significant changes, to wider Europe the research landscape may appear unrecognisable.
The infrastructure changes will cross many areas of a firm’s business form, accounting to research production, from budget process to how research is read. There are obvious challenges in building a model that will be able to satisfy the budget and funding requirements of the regime, with or without the complications of CSA management. The extent of fallout that results from the implementations may well take some months to become apparent, by which time changes will have been in place and altering the structure may be costly.
Outside of the larger asset managers who may be in a position to apply funding to these challenges, the large number of smaller firms will simply not be able to raise the necessary funds within the new structure, for the normal breadth of research they would expect. Similarly, any size firm that is considering extending their reach into a new area will be faced with a challenge of discovering which research producer they should be engaging with to source the quality of research they require. The current model of sifting through a wealth of free research will no longer be possible.
Firms will be looking to third parties for help in several key areas and a platform that can solve a number of challenges within a single environment will be well-placed to answer the call.
This article was first published in edition 8 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
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