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Whitepaper for Unbundling

Last month, the UK’s Financial Conduct Authority (“FCA”) proposed to allow investment managers to once again ‘bundle’ payments for third-party research and broker fees, reversing a key part of the EU’s Markets in Financial Instruments Directive (“MiFID II”). This proposal provides buy-side firms more flexibility on how they can purchase investment research. This move shows a change of stance by the regulator on the EU’s “unbundling” rules, which it supported initially prior to Brexit.

Overview

Under MiFID II, which went into effect on January 3, 2018, the European Securities and Markets Authority (“ESMA”) required that investment managers must pay separately for research and trade execution services, with investment research to be paid for by asset managers in one of two ways: by the firm itself out of its own bottom line (the P&L model) or from a dedicated research payment account (“RPA”). Following the FCA’s initial review in 2019, the regulator said that the rules had improved asset managers’ accountability over costs, saving millions for investors, however, the Regulator has now taken a different stance in its recent consultation paper, stating that the current options available to UK asset managers are “either operationally complex or may favor larger firms, impacting competition”.

“The requirements on firms in relation to this new option would include them establishing: a formal policy on use of the approach; a budget for the amount of third party research to be purchased; ongoing assessments of research value and price; an approach to the allocation of costs across their clients; a structure for the allocation of payments across research providers; operational procedures for the administration of accounts to purchase research; and disclosures to clients on the firm’s approach to bundled payments, their most significant research providers, and costs incurred.”

Regulatory Divergence

The FCA has also acknowledged that the unbundling rules could impede UK investment managers’ ability to purchase investment research produced outside the UK, particularly in the US, stating that “MiFID II requirements may consequently create impediments to UK investment managers operating internationally (placing them at a competitive disadvantage), and could impact investment performance by restricting the information they can access”. In the US, which allows bundling through the use of “soft commissions”, under which payments to broker-dealers for execution and research services are combined. The use of structures such as commission sharing arrangements (“CSAs”) is also prevalent and allows investment managers to pay a broker-dealer for trade execution, yet to have the portion of commission allocated for research to be used to purchase it from a different broker-dealer or independent research provider (“IRP”). However, US broker-dealers must register as investment advisers if they wish to accept payment for research separate from execution commissions because separate payment can be treated as special compensation for the purpose of the Investment Advisers Act of 1940. The Investment Advisers Act of 1940 provides an exclusion from the requirement to register as an Investment Adviser if the investment advice provided by the broker-dealer is purely incidental to the brokerage business and they receive no “special compensation” for providing the advice. In 2017, the Securities and Exchange Commission (“SEC”) issued a no-action letter providing relief to US broker-dealers accepting unbundled payments from EU and UK asset managers for research services. The relief expired in July 2023 and the FCA specifically noted this relief’s expiration and the importance for UK asset managers to be able to obtain research from global sources without impediments to remain globally competitive.

Cost Transparency and Best Execution

The EU has long recognized the issue of MiFID II on cost transparency, and while the benefit of cost transparency has been recognized, the MiFID II rules have adversely affected independent research, its costs, and availability. Further, investment managers are bound by achieving best execution rules. Under these, firms have an obligation to “take all reasonable steps to obtain the best possible result for their clients.” While research services are not a factor in assessing best execution, no additional costs to investors are expected specifically due to best execution considerations. However, increased costs to investors would be both higher and more difficult to quantify, as they would potentially consist of not just increased payments for research, but also increased trade execution costs to procure such research. Even with best execution policies in place, there could be increased costs to investors if investment managers have an incentive to trade more to gain access to research that is provided alongside execution services. This potential conflict of interest makes transparent cost disclosure an important potential safeguard for investors, and so is considered in the Consultation. Costs from changes in, and transparency of, research pricing The MiFID II reforms were intended to ensure research could be priced transparently and separately. There is a risk that the introduction of bundled payments could reduce transparency and foster opaque charging structures, and thereby also increase the price of research on a “per unit” basis.

The practice of bundling trade execution and research can also raise competition concerns. These include reduced price transparency impeding competition, and competitive advantages for full-service brokers (offering both execution and research) over execution-only brokers and IRPs. When changes were introduced under MiFID II, it was expected that they would result in improved competition in the markets for both research and execution services. In 2019, the FCA found that competition had driven down costs for written research, enhanced price transparency (but price discovery was still evolving), and led to increased use of a wider range of counterparties for execution services.

Implications

Under this CP, there still a risk that trade execution is directed to specific brokers to ensure continued access to research. However, an engagement conducted reviewing the US model confirmed this risk can be mitigated by allowing commissions paid to one broker to be used to procure research from another broker or IRP. The proposed changes include amending COBS 2.3A.19R(5) to include the addition of short-term trading commentary and advice linked to trade execution to the list of acceptable minor non-monetary benefits. Further, the emphasis on the operational requirements which will be bestowed on investment managers will put an emphasis on a firms’ ability to separate research and execution costs, track and report these accordingly, and not have best execution affected by the ‘rebundling’ of services.

The FCA’s consultation on the proposed reversal of the ’unbundling’ rules will close on June 5, 2024 and the FCA aims to publish any updates to the rules shortly after.