Of the many challenges thrown up by MiFID II, tackling unbundling rules for research pricing may not have been top of everyone’s to-do list.
However, come the much-debated January 2018 implementation of MiFID II, the way asset managers consume research materials will get more difficult, and they will have to be prepared—or at the very least, aware.
According to Jeremy Davies, co-founder of institutional research marketplace RSRCHXchange, the new rules in this area are centred around “giving visibility to the end investor as to what is being spent on research and what is being spent on executing trades”.
Traditionally, the cost of research will have been bundled in with the cost of execution, emerging in one cover-all fee for the investors. If the cost of a trade is typically 10 to 15 basis points (bps), Davies says, only about 5 bps goes towards actually executing the transaction. The other 10 bps would go on other services provided by the asset manager, including research, although there is no way for investors to know exactly what is spent where.
With regards to this, there are three major changes coming in to effect under MiFID II. Firstly, asset managers are required to set an advance budget for their research spend, to stick to it, and to assess it at regular intervals.
Secondly, research must be financed from a separate, imaginatively named ‘research payment account’. This can be funded either out of the asset manager’s own pocket (and while some have already opted for this, it’s not likely to be the most popular choice); paid for by the asset owner through an additional, research-specific fee; or paid through a modified commission-sharing agreement, similar to the current model. The difference for this latter option is that the asset manager will have to be specific about how much of the investor’s fees are being diverted to the research payment account.
The final major issue poised to arise is that asset managers will be obliged to provide an audit trail to the end investor, showing exactly what their money has been spent on, and what has gone on research.
Davies says: “That’s not revolutionary, but at the moment that money is just spent without much record-keeping around it.”
“The audit trail requirement will mean the asset manager has to look at it and appraise what they’re getting in the way of research, what they actually used and why, and what they paid for it, and why.”
This final point seems to be the crux of the new rules—and it is echoed throughout the whole of MiFID II—investors should know where their cash is, and more specifically, where their fees are going.
Neil Scarth, principal at Frost Consulting, says: “Historically, the institutional investment research market has been very opaque, as traditionally research charges have been deducted from asset owner returns. Regulators clearly believe that the efficiency of research spending can be significantly improved.”
And this improvement is by no means inconsequential. According to Davies, the global research market for equities alone is worth about $20 billion.
He estimates that for large asset managers bringing the costs in-house, it could end up as their second-biggest expenditure, after wages, in some cases amounting to tens of millions, even hundreds of millions, every year. Clearly, it’s an important thing to gain some clarity around.
For the smaller asset managers, however, pricing up their research spend, as it stands, can be a little more complex, and set to change imminently. The current pricing model is, as Davies puts it, “an oddly socialist mechanism within a capitalist industry”.
Research providers send the same written research reports to all asset managers, regardless of size, and the cost is based on trading volumes, not the amount of data consumed.
So, a large firm, trading billions of dollars, will pay considerably more that a boutique manager that trades relatively little.
Under the new rules, small firms will struggle to receive the same levels of research that they have previously.
Davies says: “If you try to level that playing field then you can see that the little guys would need to pay a lot more for their research than they were paying before.”
However, while those larger firms might make use of all the research at their disposal, looking in some detail at every country, asset class and sector, smaller managers are more likely to siphon out quite specific pieces of information.
A Belgian asset manager, for example, running a particular type of regional tracking fund, would only realistically consume research on the Belgian market. It would still have access to a lot of data, but would rarely, if ever, make use of it. Whether to their detriment or not, smaller asset managers may end up paying the same amount for their research as they always have, but receiving considerably less information.
Scarth says: “The changes will not be detrimental to smaller asset managers, per se. If many large asset managers were to decide to pay for research from their own profit and loss statements, rather than charging the client (as is predominantly the case now), the lack of scale for smaller asset managers could diminish their access to research, if they had to pay for it directly.”
If it eventually becomes a regulatory mandate for asset managers to pay for research out of their own pocket, smaller firms would undoubtedly be at a disadvantage. However, according to Scarth, this is fairly unlikely.
Davies suggests that the real challenge for asset managers will be the transition period, not in the actual new way of doing things. The RSRCHXchange platform is designed to allow asset managers to pick and choose the research they require, and to only pay for what they consume.
“It’s difficult because the transition is from a world where asset managers were drinking from a fire hydrant of research to a world where they need to be far more selective,” says Davies.
“It could be a bit of a shock to the system, but I think it is critical that people start to adapt rather than going through the process of having no research at all for a time.”
While it may be a challenge and something of a culture shock, with the regulatory drive for transparency and investor protection since the financial crisis, it’s hardly a surprise that such significant figures will no longer be allowed to be spent in such an opaquely bundled manner. In fact, according to Scarth, this drive toward unbundling of execution and research payments has been around since the Myners Report of 2001.
He says: “As the drive towards transparency over trading and execution costs has taken hold, scrutinising access to, and costs of, investment research was a natural progression. Undoubtedly, MiFID II is forcing this change, more so than any previous attempts towards unbundling.”
Davies agrees that MiFID II has acted as a catalyst for this change. However, he maintains that, even for firms outside the reach of the directive, having no documentation, no audit trails and no transparency around what could be its second-biggest cost item is at best ill advised.
“Before now, I don’t think the market had changed in decades,” he says.
“Now they’ve looked at it, this clarity is something that firms will want. And so, even in geographies outside of MiFID II we feel confident that the genie is out of the bottle.”
While service providers are clued up and ready to tackle the issue, asset managers themselves have been a bit quieter, the suggestion being that they’re still working on this section of the new regulation. Perhaps understandably, given the many, many challenges involved in the run-up to implementation.
A spokesperson from BNP Paribas confirmed that the institution is still looking at the research costing situation.
“The asset management industry faces a number of issues with regard to the implications and implementation of MiFID II,” the BNP Paribas spokesperson explained.
“These include valuing and paying for research. In line with many of our peers, we currently have commission sharing agreements in place. In light of the changing regulatory environment, we are continuing to review our approach.”
The new procedures will mean looking into the nitty gritty, granular detail of their research, not only to understand it themselves but to report this detail to regulators and asset managers in the most transparent manner possible.
Scarth calls MiFID II “the most significant global change in research funding since the US Securities and Exchange Act of 1934”. He adds: “Most managers will have to significantly change their research procurement process.”