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he hidden problems Europe uncovered during unbundling

Is the SEC about to unbundle your business?

February 27, 2019 Thought-leadership

This is the first in a three-part series of articles to help asset and hedge managers answer their clients’ questions about the unbundling of payments for research and trading and understand what a best in class research management system looks like. 
By next summer, the Securities and Exchange Commission (SEC) must set out a final position on the unbundling of buy-side payment for research and trading. For US firms still getting to grips with unbundling, an assessment of the potential cost and operational impact should begin today. Winning mandates from funds could hinge upon giving an informed response to this massive change.
Major US asset managers, including Capital, T. Rowe Price and MFS, along with the Council of Institutional Investors (CII), are pushing for a standardised approach across markets. Greater transparency around cost should introduce competitive pressure on the trading and research services provided by broker-dealers. It creates clarity around the cost of investing versus trading for the end beneficiary, giving them an insight into an investment manager’s performance, unobscured by third-party costs.
The first big step change is that a broker-dealer registered under the Securities Exchange Act of 1934 providing research to an institutional investment manager would establish an investment adviser/client relationship, and the broker would have to register as an investment advisor under the Investment Adviser Act, creating additional regulatory obligations for it.
Secondly, where research has not previously been valued independently of execution, it would now have to be costed, and mechanisms put in place to decide how it is paid for – either by the investment manager’s own balance sheet or by clients. Corporate access will also need to be considered as a service to be paid for.
Having greater insight into these costs allows asset managers to pick and choose research based on value. On 25 February 2019, Andrew Bailey, chief executive of the UK’s Financial Conduct Authority reported that savings for investors in the UK were expected to amount to nearly £1billion over the next five years.
What are the next steps?
The imbalance between European and US rules are already a problem that regulators have taken temporary steps to address (see box: Balancing MiFID II with US regulation). US investors are paying for research without being shown the costs of that research while European investors have that transparency. Asset managers who are able to provide greater transparency around where and how funds are allocated can enjoy greater confidence from their clients.

Balancing MiFID II with US regulation

Broker-dealers and investment firms that operate across the US and Europe have already been faced with this dilemma, as unbundling became obligatory in January 2018 under the European Commission’s Markets in Financial Instruments Directive (MiFID II). To tackle this issue, the SEC published three no-action letters in late 2017, granting 30 months of no-action relief for firms from January 2018, so that:
  • Brokers complying with MiFID II payments for some clients were not considered investment advisors,
  • Investment advisers might continue to aggregate client orders despite clients paying different amounts for research because of MiFID II requirements but receiving the same average price for assets and trading.
  • Separation of payment of research using research payment accounts (RPAs) from execution – admissible under MIFID II – would fall within the Exchange Act Section 28(e) safe harbour.
Some sell-side firms have acted already; Bank of America Merrill Lynch has registered its research arm as an investment adviser. The SEC itself had asked for data and feedback on the impact of MiFID II from industry participants up to 31 January 2019, in order to supplement its own study of the effect the rules were having upon the market.
The next steps depend on the SEC’s view of MiFID II. In December 2018, SEC Chairman, Jay Clayton, called for feedback on how MiFID II research provisions were hitting broker-dealers, investors and issuers of all sizes, and whether there had been an adverse effect on research availability. In Europe, only the French market regulator has voiced any concern, noting that smaller cap stocks may lose coverage.
For US businesses on the buy and sell-side who are yet to react, much will hinge on the regulator’s assessment. What may swing the vote is fiduciary duty. The pressure from end investors – as represented by the CII – to receive more granular investment costs will prove hard to push back on. Global fund managers are already voicing concern about two-tier transparency that harms investors.
Faced with a deadline of the 3rd July 2020, senior buy-side managers need to begin an assessment of their research use, along with the potential costing and payment models, thereby laying the groundwork for potential change. Awkward questions being asked by potential clients this year should be met with intelligent answers.
Upcoming in the series:
  • In the next article we look at the five biggest surprises that European firms discovered during the unbundling process.
  • The final article looks at what a best-in class research management system looks like, taking into account regulatory, technological and drivers from within your own business.

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