MiFID II fallout: unbundling the research payments dilemma for fund managers

By Jack Pollina, Managing Director, Head of Global Commission Management and Hedge Fund Business Development, ITG

Published: 18 December 2015

In September 2015, the European Securities and Markets Authority (ESMA) finally announced its long-awaited capital market reforms. With 1,500 pages to wade through and 28 new rules to digest, it’s fair to say that fund managers have plenty on their plates. While many will be thankful for the level of granular detail regarding who needs to report on what to whom and when, the question of exactly how research will be paid for still remains.

It’s a question that’s likely to hang in the air for a while yet. Although expected in November, the latest chapter in the lengthening story is that the delegated acts probably won’t appear from ESMA until at least February 2016 and perhaps even March, with rumours that the European Commission may send some of the rules back to the regulator.

Until then, much uncertainty surrounds how exactly fund managers go about paying for research. But one thing we know for sure is that investment managers must set their research budgets in advance either through Commission Sharing Arrangements (CSAs) or – in the event that the EC decides that managers have to pay for research separately – via a Research Payment Account (RPA).

There is currently a lack of clarity stemming from national regulators’ differing interpretations of ESMA’s take on CSAs, which enable fund managers to access research and execution from separate providers while paying for both through dealing commissions. Back in February, the UK’s FCA argued that CSAs are linked to transacted volumes and therefore not allowed, as ESMA states that research costs should not be linked to the volume or value of execution services. Yet, other European regulators have argued CSAs will still be valid, and at the moment it looks as though the French are making headway with their push to convince the Commission to allow portfolio managers to keep using them. In any case, fund managers cannot afford to wait for the final results: there are fundamental questions that need addressing today.

The most pressing of these is exactly how fund managers will be affected. Regardless of whether CSAs survive, fund size is an important factor. If the cost of research goes up, smaller investment managers may be disadvantaged given the relative impact any increased expense would have on a small firm. Then there is the administrative burden of setting a research budget – deciding how much money to set aside will be challenging. However, larger players may find it easier as their budgets likely have more capacity to absorb any extra research costs.

As if this wasn’t enough to think about, MiFID II now encompasses all asset classes, so confusion also remains over how firms should allocate research payments. For example, can an investment manager who consumes research for currency and bonds share the cost with an equity-focused colleague? If so, how should they allocate the cost? Additionally, fund managers will have to contend with extra expenses if research is unbundled as VAT costs will be piled on top.

One might think that once research has been allocated and costs factored in, fund managers would be all set, but there are other points to consider. Since trading desks will gain greater discretion over which execution brokers to trade through, the quality of algorithmic and electronic trading will become even more important.

It may take time for these changes to filter through, but time is still very much of the essence for fund managers. Both ESMA and the Commission have made a case for delaying the January 2017 implementation date, but for now it remains hardcoded in the regulatory texts, and we don’t yet know whether any delay will be wholesale or take a phased-in approach. The challenge for trading desks is to reevaluate the tools available to them now to ensure they achieve best execution.

So what immediate steps should fund managers take to prepare for this new and highly complex environment? Well, unbundling broker relationships to gain transparency and differentiate between execution and research is a good place to start. CSAs can certainly help with this. CSAs are designed to get the best research and execution from separate providers, without incurring additional costs or administration. Fund managers can also compare past research budgets with future expectations, as well as assess whether portfolio managers are consuming all the research they currently receive. We also believe that tools that allow fund level reporting will become increasingly important.

It would be unwise for fund managers to break from CSAs now, as we await the European Commission’s final decision. As far as long term strategy, much will depend on whether the rules are implemented as a regulation or directive. If a regulation, they must be implemented uniformly across Europe, while a directive provides more flexibility to local policymakers and regulators in how they interpret and apply the rules. Regardless of the outcome, fund managers who are already tackling the key questions will be best positioned to demonstrate full transparency to clients.