In mid-December the European Securities and Markets Authority issued the long-anticipated final draft of its new regulatory framework, the Markets in Financial Instruments Directive II. Chief among the concerns of market participants: how MiFID II would handle research payments.
The answer, it turned out, generated a collective sigh of relief and mostly positive reviews. Yet some questions and worries remain.
“They went farther than I expected but not as far as I’d feared,” reports Michael Mayhew, chairman of Integrity Research Associates, a Darien, Connecticut–based consulting firm that reports on trends in the global investment research industry.
The fear — shared by many — was that ESMA would forbid the use of trading fees to pay for investment research, as the regulatory body appeared to propose last summer. “Clearly, they have changed their approach from their original proposals,” observes Daniel Godfrey, chief executive of London’s Investment Management Association. “The industry asked them not to effectively ban the ability for investment managers to be provided with research paid for by clients’ dealing commissions, and ESMA has listened to that request. They have proposed a regime which will allow for client dealing commissions to be the source of payment for research.”
But the report lays out fairly stringent rules about transparency, pricing and how payments are to be made, leaving many observers still trying to gauge their impact. “What they’ve done is propose a regime that will apply strict governance around the communication, agreement and transparency of those costs, to ensure that the conflicts of interest that are inherent in the business model are managed effectively,” explains Godfrey.
Specifically, ESMA calls on the sell side to separate research payments from execution fees. For the buy side, research budgets must be established in advance and made plain to clients, with each agreeing to its share of the expense before the budget is implemented.
The scheme will “allow portfolio managers to receive research from third parties and to charge clients for that research,” says Livia Vosman, an ESMA spokesperson in Paris. “The proposed regime does not oblige firms to pay for research out of their own resources,” she adds, but it does require them to budget their research costs on a per-client basis, securing agreements from each investor client.
Broadly, the new directive strikes many people as being on target. “It does seem to match with their goals of transparency, of protecting ultimate investors and of managing conflicts of interest,” says Steve Kelly, who runs opinion surveys of analysts and corporate managers for WeConvene Extel, a Hong Kong–headquartered outfit that facilitates meetings among corporate leaders and representatives of the buy and sell sides.
“It certainly takes steps in that direction,” agrees Mayhew, of Integrity Research. “Providing a level of transparency is a good thing, and that will reduce the perception of a conflict of interest. But there is still a view, at least from the regulators, that research is or could be an inducement, that there is a potential for conflicts of interest, which is why ESMA is changing the rules. Most folks in the industry don’t believe research is an inducement.”
The real devil will be in the details to come, for the draft doesn’t tell market participants how to implement its directives. An open hearing is scheduled for February 19 in Paris, and public comments are welcome through March 2. Then, ESMA will finalize its recommendations and send them to the European Commission for approval before year-end. The new regulations will take effect at the start of 2017.
“The latest ESMA documents provide a strong framework, although of course there is a lot of detail here [to work out], which will need careful analysis,” adds Kelly, who is based in London.
One especially troublesome issue involves the mandate for research budgets. “The ESMA position now is that such budgets need to be advised to ultimate clients in advance, and any increase to the budget needs to be agreed by each client in order for it to happen,” Kelly notes. “I don’t think it is clear exactly how this might work in practice.”
The problem is not that asset managers can’t communicate with their investor clients, of course. Rather, it is the repercussions of that communication that give some pause. “What’s crazy to me is, what do you do if you have ten clients and only nine say, ‘Fine, increase your research spending’?” asks Mayhew. “What do you do if one client says no? Are you going to treat that client differently? And to avoid a free-riding problem, shouldn’t you treat that one client differently?”
Mayhew acknowledges that setting a transparent research budget, and having to justify it with clients, should improve efficiencies down the road. “That will be good for the ultimate investor, but it’s probably not good over the long haul for the big sell-side firms,” he says.
The bulge brackets’ losses, however, could be independent providers’ gains. “If I’m paying this large sell-side firm $1 million for research, and that same amount will get me ten different independent firms’ research, I’m probably going to have to reconsider my budget allocations,” Mayhew contends. “European asset managers will likely start reducing their dependence on the large sell-side firms and increasing their reliance on independent research.”
Besides independent research, another gainer could be those asset managers that use commission-sharing agreements. CSAs provide a method by which fund managers can divide trading commissions between the firm that provides execution and the one that supplies research advice, furnishing all concerned with a clear accounting of how much is being paid to whom and for what.
“The use of CSAs as the payment mechanism is likely to increase,” Kelly believes, “especially among continental European buy-side firms, which have generally been far less receptive to using CSAs up to now.”
Investment banks that already use CSAs may be the first to see their businesses grow, Mayhew adds. “While CSAs weren’t directly mandated by ESMA, they actually provide one of the only existing vehicles to allow this kind of research budgeting and transparency to occur,” he says.
At issue, too, is how the Financial Conduct Authority will integrate the new standards. The U.K. regulator has already banned using commissions to pay for corporate access, judging management introductions to be outside the realm of substantive, proprietary research. In many ways, the MiFID II draft surpasses the FCA’s strictures.
“ESMA goes further in respect of saying the buy side must have a separate payment account for all research and advisory payments, with budget approval via clients, and even clearer separation from any trading commission spending,” Kelly explains. “ESMA is also more explicit in the need for transparent pricing of research services.”
But the FCA could ultimately outdo MiFID II. As the regulatory agency of a member country of the European Commission, firms under its purview will have to abide by all new limits and parameters — at a minimum. But there’s no maximum when it comes to the degree of oversight a national regulator can demand, and that’s where things get really complicated.
“This is a bit multifaceted,” Kelly points out. For example, the FCA requires “hard dollars for organizing and logistics of a road show, say, but permits commissions for the analysis and reports from an analyst that go alongside it.” ESMA’s proposed regulations, however, refers to certain “minor nonmonetary benefits” that the sell side can provide without separate billing, such as conferences and seminars. “This means ESMA is saying that parts of what the FCA would define as corporate access are okay to use commissions to pay for — or at least that is how I read it,” he says. “In this regard, ESMA is going less far, as it were, than the FCA, although personally I think it less likely the FCA will change its stance on corporate access.”
Obviously, much remains to be ironed out. “The nuts and bolts will now be a matter of the conventional debate, discussion and lobbying, to ensure that the regime is workable, fits the purpose and is no more complex or expensive to implement than it really needs to be,” says Godfrey, of the Investment Management Association. “But that’s the ordinary course of business when dealing with new regulations, to try to shepherd or navigate them to a place where they meet the principal objectives of regulators and policymakers while leaving as much of the customers’ money on the table as possible.”