Guidelines from ESMA will have a profound impact on brokers and their clients. Those looking to make a smooth transition will need to make some important choices, but they also have an opportunity to position themselves for the future. Experts from GBST take a look
For the financial industry, an era is about to end. The European Securities and Markets Authority (ESMA) is expected, later this year, to issue guidance spelling out how the cost of broker-provided or independent financial research should be broken out and charged to clients.
This dry-sounding change may not seem as transformative as some of the landmark measures that have been enacted in the wake of the global financial crisis, but it is, and it has far-reaching consequences for how both the sell side and the buy side do business.
The changes are part of a drive to increase transparency in terms of what banks and brokerages do and how they charge clients. The measure will mark the end of nearly a decade and a half of self-regulation, during which investment banks and their institutional customers were largely left to themselves to come up with a practice commonly known as commission-sharing agreements (CSAs).
Many concede that CSAs have little chance of surviving in their present form, although some industry participants believe that CSAs, with some changes, represent the best approach.
Whatever replaces them will require sell-side and buy-side institutions to make significant changes both to their back-office systems and their business practices.
At the moment, broker costs are based on an equity market model that has three components: a charge for execution, an amount for providing research and a small market fee, which is essentially the cost of doing business.
“While there is an element of market charges attached to a commission value, the real issue is trying to dissect any research payment from the cost of execution,” says Denis Orrock, CEO of financial software and services provider GBST.
What’s more, in following an equity market model, ESMA is raising another issue for the industry. “ESMA now is looking to implement this idea across other asset classes, which means potential unforeseen consequences in the fixed income world,” says Shaun Blake, a principal partner at consultancy Sheperdine Sand.
“That’s a massive headache for organisations to comprehend at this stage. Research and commission are embedded in the pricing model, so there are fundamental changes on the way.”
A major focus in ESMA’s efforts is providing investor protection, but this raises yet another issue. The UK Retail Distribution Review sought to bring transparency to retail investors by ensuring commissions were disclosed up-front rather than through murky trail commissions paid by product providers. ESMA is trying to apply similar principles in the Markets in Financial Instruments Directive (MiFID) II to the institutional side, but the level of granularity required will be difficult to administer on both sides, with some vendors currently unable to meet this requirement.
Rising to the challenge
Once ESMA comes up with a decision on commissions, there will be three key factors market participants will need to consider.
The first factor is what type of technological solution they pursue. Second is whether they can build a robust solution, or whether a vendor can deliver one in time for the ESMA changes due in 2017. Finally, there is the question of future-proofing operations for the inevitable changes in regulation that will follow as processes are bedded in.
“At a technological level, firms should consider taking a holistic approach to codifying agreements between brokers, asset managers and funds,” says Nick Clarke, head of products at GBST Capital Markets.
“Market participants will need a system that can log any transaction, and by extension log a transaction against a research account based on a complex set of rules. Whatever the rules that ESMA finally comes up with, if those elements are in place market participants should be able to make the transition relatively painlessly.”
Blake says there is an opportunity for a systems provider to act as a central hub, which does all of the filtering, calculations and comparisons and which then connects with clients’ payment systems, eliminating a large amount of manual work.
“GBST has extensive experience in middle- and back-office applications and matching around the post-trade space,” adds Clarke. “GBST is also versed in dealing with fragmented silo-based systems infrastructure, where current capabilities don’t spread across all of those asset classes.”
A second but equally important area for market participants will be how ready a brokerage firm or a solutions provider is to address the requirements that ESMA sets. These changes form just one item on a long list of new measures addressing market infrastructure and business practices. Sell-side and buy-side firms have been scrambling for the past few years to keep up with the pace of change, and allocating the time and resource to cope with more adjustments is not always easy.
Finally, there is the future to think about. Experience shows that regulatory measures are rarely set in stone. They are frequently updated and tweaked, with different formulae changing all the time. So firms need to make sure they build or choose a system that can cope with all the change. By outsourcing this function, banks and institutions wouldn’t need to worry about keeping on top of the ever-increasing amount of regulatory information.
Clarke says that modern technology allows for research budgets and commission agreements to be codified and continuously adapted as agreements and regulations change, ensuring the cost of compliance is minimised.
ESMA’s stated desire to make changes across asset classes highlights the importance of this last factor. As Europe formalises the way that research ideas are priced, having a single central solution that can cope with all the different technical issues could be a critical issue for firms.
Some firms are trying to get ahead of the curve by working with their clients to price research. At the moment, there is no clear holistic answer for the industry.
In the end, European officials are asking themselves a question that sounds simple: how should firms set a price for research? Whatever the answer, the new dynamic for market participants is likely to be anything but simple.
