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MiFID II investment research: freedom under constraint
MiFID II investment research: freedom under constraint
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MiFID II investment research: freedom under constraint

04/12/2017

Regulations usually give clear directions on what path to follow. Occasionally, there is a “comply or explain” approach, but even here, the form compliance takes is fairly prescriptive. In the case of the Markets in Financial Instruments Directive II (MiFID II) and more specifically for research unbundling, one challenge stands out as conceptually different from most regulation.

Investment research costs under MiFID 2 must be disentangled from brokerage costs but how to allocate those costs once that is done remains at the discretion of the asset manager.

Absorbing MiFID II investment research costs or passing them to clients using RPAs?

Most asset managers have narrowed down their choices to two options: absorbing the costs or passing them to clients using Research Payment Accounts (RPAs).

It may be possible to use commission sharing agreements already in place. However, many of these allocate research charges to clients based on the volume or value of transactions incurred on their behalf, which is not allowed under MiFID 2. Revising these agreements to comply may be too complex for asset managers.

Most managers, who have made a public statement about their decision, have chosen to absorb the costs themselves. In some cases, this decision was a reversal of a previous decision - after one large provider of both active and passive funds declared it would absorb the costs, a number of other fund houses changed their minds and followed suit.

Most of those who have decided to absorb the costs are larger fund managers, although even in this group, the decision is not universal. Among the smaller fund houses, the cost-benefit analysis may be different, since the costs may be harder to absorb.

Choosing how to deal with investment research costs is a balanced decision, between commercial, compliance and profitability criteria – making it different from most regulatory compliance.

Absorbing the costs is probably the simplest and look most attractive from the clients’ point of view. However, it is expensive and hits the bottom line. After one fund house announced that they would absorb the MiFID II research costs, broker coverage downgraded the fund house, predicting lower company earnings than previously forecasted.

For smaller companies, setting up a RPA may be the most viable option, if absorbing the costs would hit the P&L too hard. Larger fund managers may also go down this route. In at least one example, a larger fund house announced  it will charge research costs to customers, because it has already put work into maximising the efficiency of its research consumption and it is keen to make this transparent.

Although this is the cheaper option, it is not cost-free, as there will be a considerable administrative burden to setting up and maintaining RPAs.

What should you know to set up a Research Payment Account for MiFID II?

When setting up an RPA, the asset manager has to consider the following: setting an investment reseach budget; how to charge clients; managing full disclosure of research spending and consumption; and developing a methodology to assess the quality of research.

Under MiFID II, a research budget must be set ex-ante and communicated to clients. Any change to this budget must be agreed in writing by the clients and it must be possible to explain ex-post where the money has been spent.

Just as a formula must be found to attribute the spend to the investment managers using the research, there also must be a formula for how to charge clients, which cannot be based on the volume or value of transactions.

Possibly a tougher challenge will be to develop a robust and defensible methodology for assessing the value of research. In some cases, there may be an immediate, measurable outcome, but most of the time, it will be less obvious. How do you demonstrate the value of research that prompts a portfolio manager to hold onto a stock over five months instead of selling because of a short term dip?

Because there is no guidance from the regulator on how to do this, companies will have to develop their policy inhouse. Initially, this may seem like a burden since it is conceptually tricky and may involve putting new quality control systems in place. However in the long run, it may turn into positive since a focus on quality should result in research budget being better spent.

Some fund houses, particularly in Sweden, have already put systems in place to separate payment for research from transaction costs. In several cases, they report higher levels of satisfaction with the research they buy, while seeing a reduction in the research budget.

The operational challenge may be significantly reduced by the development of outsourced arrangements for managing client RPAs. Custodians are the natural choice for investment firms willing to open a RPA while vendors are offering RPA budget solutions.

SEC releases the pressure on US brokers for research payment

MiFID II’s objective of unbundling payment for research from transaction fees is directly opposed to the regulatory approach in the US, where brokers are strongly discouraged from accepting direct payment for research.

If the brokers do accept payment, they are required to register as investment advisers, entailing a whole new set of responsibilities and oversight, not necessarily appropriate for the institutional clients they largely deal with.

This would have left European managers unable to access most US research, while US brokers would have faced the dilemma of being cut off from a major market or having to submit to additional and inappropriate compliance burden.

This challenge has been deferred by the Securities and Exchange Commission (SEC), the US regulator, granting temporary relief to both brokers and investment managers. For 30 months from January 2018 (when MiFID II comes into force), they will be able to take advantage of a temporary respite while the SEC considers whether more tailored rules would be “necessary and appropriate in the public interest”.

In conclusion absorbing the research costs or passing them to clients using RPAs is particular to any fund house. The asset manager’s own relationship with its clients and with its brokers must be considered, as well as its historical approach to research and charges.

But whatever the decision, it must be taken soon, as the implementation date fast approaches.

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