Commission sharing arrangements in Europe will require tighter control and governance in order to comply with the requirements for research payments under Markets in Financial Instruments Directive II, the regulations covering markets in the region from 2018.
This month the European Commission published a delegated act setting out detailed requirements for MiFID II, which included the unbundling of research and execution fees. Dealing commissions for fund investors have historically combined both researching the investment decision and the cost of execution in one payment.
The European Securities and Markets Authority had proposed that fund managers either pay for research out of their own revenues or set up research payment accounts for clients with an agreed budget. The delegated acts allow modified commission sharing arrangements — which are not linked to the volume of trades — to fund research payment accounts. The text said: “The research payment account should only be funded by a specific research charge to the client which should only be based on a research budget set by the investment firm and not linked to the volume and/or value of transactions executed on behalf of clients.”
Amrish Ganatra, managing director at Commcise Software, which provides cloud-based commission management technology, posted a guest blog on the Integrity Research Associates website on the difference between CSAs and RPAs. He said: “Even when compliant, the role of the CSA is limited to providing funding, and does not address the reporting and quality assessment requirements of the new regulation.”
Ganatra explained why current CSAs do not automatically translate into an RPA. Investment firms need to be in control of their RPA and so need to reconcile any CSA that provides research funding. “We interpret this to mean that a trade-by-trade reconciliation would need to be conducted in order to provide evidence of such control,” he added.
CSAs can detail eligibility criteria such as the specific funds to be included or excluded from the agreement but this may not meet MiFID II requirements. “When a fund is excluded, this is only recognized post-trade and at that stage, the broker keeps the full service rate and the CSA is not credited,” Ganatra added. “We believe this practice might need to be reconsidered when operating within the bounds of an RPA.”
In addition CSAs are not typically covered by a research budget, which will need to be set under MiFID II. Ganatra said: “It is our interpretation that the delegated act requires budgets to be managed at the firm level. The investment firm would however have to notify its clients if the firm-level research budget were breached.”
However other firms have interpreted the act differently. Neil Scarth, principal at Frost Consulting, a regulatory consultancy, said in an email to Markets Media earlier this month that fund managers need to establish monetary (dollar) values for research and set up a fair allocation of research costs between clients – possibly at the strategy or fund level, rather than the firm level – for both equities and fixed income.
Amrish Ganatra, Commcise
Frost Consulting has launched FrostRB which gives asset managers the ability to establish monetary values for specific unpriced research products and construct monetary research budgets for individual funds to meet MiFID II research spending requirements – but does not provide access to research reports.
Ganatra added that CSAs cannot be MiFID II compliant without a robust research evaluation platform and regulatory reporting. “The important consideration for investment firms is that existing CSA administrators may struggle to deliver this requirement because they (i) typically only see eligible CSA trades (ii) may not see other asset types (iii) don’t have visibility of priced research consumption by fund (iv) don’t have visibility of the research evaluation process, and how this links back to funds or clients,” he said.
As a result some fund managers have already taken the decision to separate research costs ahead of the implementation of MiFID II. From the start of this month UK fund manager Woodford will start paying for research itself while larger rival Legal and General Investment Management is unbundling trading and research commissions and giving each of its active equity funds a defined research budget.
Mark Pumfrey, head of Europe, Middle East and Africa at the institutional block trading platform Liquidnet, told Markets Media last week: “There was relief that CSAs are still allowed although they have to be linked to RPAs and the research budget which will be onerous for the buy side. There will be a reduction in the amount available to pay for research and a focus on which providers add value.”
Liquidnet also has a commission management service. Pumfrey continued that institutions are currently reviewing their commission management processes to see if their CSA arrangements are robust as they will have to justify their research spending.
Ganatra continued that CSAs and RPAs may continue to coexist in Europe but asset managers can choose between two methods to fund an RPA. “The transactional method uses a research charge that is included alongside a transaction (or trade) to fund an RPA,” he said. “The accounting method on the other hand uses a fixed charge that is applied to each fund and is most often accounted for as a daily accounting “accrual”.”
This daily accrual would need be transmitted to the asset manager’s chosen RPA administrator(s) at a pre-agreed frequency (often monthly or even quarterly) so that the RPA administrator can complete all payments for research from this research balance.
However in order to comply with MiFID II the investment firm must also provide evidence that they have regularly assessed the research and only paid for research that meets agreed quality criteria.
“They also must have the ability to provide reports to clients detailing where research dollars have been spent and how these amounts were justified,” Ganatra added. “A fully integrated research evaluation and consumption tracking solution that considers a holistic view of research spend across the firm (including other asset types) will eventually be required.”
Vicky Sanders, co-founder at RSRCHXchange, a marketplace for institutional research, told Markets Media earlier this month that it has become normal for fund managers to set research budgets.
Sanders said hard dollar payments work well for some funds while commission sharing arguments or research payment accounts will better suit others. “On RSRCHX we still see the overwhelming majority of purchases made with CSAs,” she added.
RSRCHX is the name of RSRCHXchange’s research platform. The firm launched last year as an online marketplace for fund managers to buy institutional research and now has more than 125 multi-asset research providers on the platform. Fund managers can pay by subscription, purchase individual reports with cash, use commission sharing arrangements or the new MiFID II research payment accounts – and meet the enhanced record-keeping requirements by measuring and monitoring consumption.
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