The revised Markets in Financial Instruments Directive (MiFID II) introduced new rules requiring investment managers to pay for investment research either from their own funds or via a research payment account (RPA) funded by an explicit client charge. In addition, research providers are required to price research separately from execution. These rules seek to increase the transparency of research costs for investors, reduce conflicts of interest where research is bundled with execution, and promote competition in the research market.
As expected, the investment research market is a key focus area for EU regulators following the implementation of MiFID II. At its recent 2018 Asset Management Conference, the Financial Conduct Authority (FCA) announced its intention to carry out a multi-firm review of how firms are complying with these rules and whether research markets are functioning well. In parallel, the French regulator has announced that it will be assessing the impact of these rules as one of its 2018 strategic priorities, while the European Commission has issued a call for tender on a study on the impact of the rules on research relating to fixed income products and small and medium-sized enterprises.
This blog summarises what the FCA’s review will cover, discusses the challenges investment managers face in meeting the new requirements and how they can respond to these, and explores how the research market might evolve in the future.
What will the FCA’s review cover?
As part of its review, the FCA will issue a data request and conduct face-to-face interviews with investment managers, sell-side firms and independent research providers. The FCA’s supervisory focus areas will include sell-side research pricing models; investment managers’ assessments of what constitutes substantive research; the research budgeting process; governance of RPAs; oversight of delegated portfolio managers’ research procurement; and the role of independent research providers. While independent research providers will be included in the FCA’s review, the FCA will have a greater focus on broker-provided research because it considers the risk of conflicts of interest to be higher. The review is expected to take around 6 months.
What are the challenges and how can firms respond?
Investment managers need to ensure that they are not accepting research on terms which could still be considered an inducement. Under the rules, firms must agree payment terms prior to receiving research. So-called “all you can eat” models, where a fixed price is paid for an unspecified amount of written research and bespoke interactions with analysts, are more likely to be considered non-compliant.
A key challenge for investment managers is to assess the value they receive from research and to decide how much they are willing to pay. Many investment managers are using tools to help them track how much they use and value the research they receive across all their desks to feed into this assessment. Many have reduced the amount of research they consume and some are carrying out more research in-house so that they can tailor it to their needs.
Due to competitive pressures, the majority of investment managers have opted to pay for research using their own funds rather than setting up RPAs. Investment managers using their own funds need to factor research costs into decisions about their product mix and pricing. It is not yet clear how these costs will change over time as the market is still in the price discovery phase. The separation of research costs from execution has also led to a reduction in execution costs, which may improve the performance of some funds, especially those with more active trading strategies.
Investment managers also face a number of operational challenges, including monitoring both interactions with research analysts and written research received. In some cases firms have found it difficult to determine exactly what constitutes research, although a greater market consensus on this is building over time. Firms need to take a clear view on how they define research internally to ensure that they are being consistent and can justify their approach.
The FCA does not consider corporate access to be research and does not allow it to be paid for with client money. If a broker sets up a meeting at the request of an investment manager, this is likely to require payment to avoid being considered an inducement. However, if a broker is organising meetings on behalf of an issuer and these are open to a large number of investment managers, this is likely to be a non-monetary benefit which does not require payment. Firms need to have a clear policy on which broker-arranged interactions with corporates require payment.
Global investment managers need to consider under what circumstances they can share research across their group entities given different rules in different jurisdictions. Many have opted to pay for research across their whole group, including in jurisdictions where this is not required, so that research can be shared between group entities without breaching the MiFID II rules. In the US, where payment for research is not permitted, the SEC’s no action relief letters allow broker-dealers to receive payments for research from EU MiFID firms until July 2020. It remains to be seen whether EU and US regulators will reach a longer-term agreement allowing US broker-dealers to provide research to MiFID II portfolio managers and their US sub-advisers.
Some small and mid-cap markets are seeing less research coverage, which can reduce the liquidity of their securities and cause more volatility. This can be a challenge for investment managers operating in these markets, but may create new market inefficiencies and associated investment opportunities.
How might the research market evolve?
We are already seeing some consolidation in the research provider market as investment managers decide which research providers are delivering truly valuable research, and this trend is likely to continue. Some research providers may find that the price investment managers are willing to pay for their research makes it uneconomical for them to continue their current level of service.
Some investment managers have responded to MiFID II by increasing the amount of research they conduct in-house, and this trend is likely to continue as technological changes make the investment process more data-driven. Many investment managers are already collecting and analysing more data from alternative sources (such as web-scraped data, search trends, web traffic or consumer transaction data) to feed into their investment strategies, and while some access such data via sell-side firms, most collect the data themselves or source it from data vendors. Some investment managers are also developing artificial intelligence tools to analyse large datasets, which is likely to increase the amount of data they can process and incorporate into their decision-making. This may reduce the demand for research from external providers in the longer term.
The MiFID II payment for research rules are a key focus area for the FCA, as well as other EU regulators. Investment managers need to be able to demonstrate that they have systems and controls to ensure that they are not accepting research or corporate access in breach of the inducements rules. Over time, there may be momentum towards consolidation in the research provider market as investment managers give greater scrutiny to the value of the research they receive. More research may also be conducted by investment managers in-house as the investment process becomes more data-driven.