The second Markets in Financial Instruments Directive (MiFID II) is fast becoming the dominant black hole of 2017, and nothing can escape it. Irrespective of where you are based or where you sit in the trading and investment process, if your clients or counterparties need to comply with the MiFID II requirements then you are also very likely to be affected by this regulation.
MiFID II extends far beyond European borders—for example, a branch of an EU firm in New York or Singapore is still captured by MiFID II rules. Similarly, if you are a broker-dealer trading with an EU asset manager, or a custodian looking after its assets, you will be directly affected by the requirements from January 2018 onwards.
Looking specifically at those affected among the buy-side, MiFID II is set to have a substantial impact on the middle-office processes of these firms. In this area, there are two pain points that are receiving a large amount of focus.
The MiFID II requirement to use legal entity identifiers (LEIs) for transaction reporting will likely trigger a surge in LEI issuance in the next few months, and so our advice is to act now to avoid being caught up in the last-minute rush to register.
Even once a buy-side firm has obtained its LEI, there are other considerations to be made. Distribution of LEIs is not centralised, so the provision of the data from the LEI holder to its network is largely an informal process. A buy-side firm that acquires an LEI will need to send it to its broker and custodian network. Entities within the supply chain such as exchanges, trading platforms, sub-custodians, fund administrators and trustees, may also need the data.
The existence of a global LEI standard is a major step forward, but there is still a long way to go to make it truly effective. A harmonised distribution model would be very complex to develop, however it should certainly be viewed as a long-term strategic priority. Perhaps the biggest issue here is market behaviour. Until LEIs are viewed as a tool that promotes both efficiency and risk mitigation, the LEI system will always be less effective than it could be. LEIs must be embraced, not endured. The MiFID II requirement to adopt LEIs may well present a few challenges, but it is relatively easy to ascertain what changes will need to be made to achieve compliance. By contrast, the subject of commission unbundling is much more complex, and therefore harder to resolve.
In a nutshell, under MiFID II, buy-side firms are required to either pay for research, like they do for other services, or use client commission money to pay for it and control it through a new mechanism called a research payment account (RPA). So-called ‘free research’ no longer exists and investment managers must switch from a ‘push model’ to a ‘pull model’, whereby they request and pay for research instead of receiving it unsolicited, and without overt cost.
The operational overheads of operating an RPA appear to be considerable, so much so that service providers are beginning to offer commercial third-party RPA management services. It is notable here that RPAs are not just a name change for the existing commission sharing agreements (CSA) model.
In the UK market, the issue of ‘soft’ and ‘bundled’ commission goes back a long way. It first became a policy priority in 2001 when the Myners Report, establishing a best practice approach to investment decision making for pension funds, was published. Some 16 years later the issue remains relevant. In short, the Myners Report advocated abolition of soft commissions, which at that time were rebated back to the buy side to pay for a wide range of additional services. ?After many years, the CSA model emerged, outlining that commissions paid to brokers could be shared with third parties that provided research. While this was an improvement, it did not ultimately fix the issue. Does the research that is being purchased by a broker deliver any real value to the underlying client? Why can’t buy-side firms simply buy research in a transparent manner?
There is no reliable data available about the state of market readiness for this fundamental change. With less than four months to go, it is abundantly clear that many hundreds of buy-side firms are undecided about how to fund research—through the use of RPAs, or through their own profit and loss (P&L).
What’s causing the delay? As ever, answering the ‘who pays?’ question is proving challenging. Today, the standard model is for a fund to pay for the research, while a CSA is used to provide the cash. Switching to an RPA model means the fund continues to pay, but the investment manager has to justify all individual purchases and properly account for them. In the P&L model, the investment manager pays for research and can either absorb the costs or seek to add the expense to the fees it charges its clients. It’s the latter scenario that appears to be causing some headaches with pension funds and plan sponsors, which are saying research costs should be a component of the existing fees they already pay.
With MiFID II implementation just around the corner, post-trade issues such as research payment policies need to be addressed sooner rather than later. However, what is also critical is that market participants realise how far-reaching MiFID II will be. If a firm’s clients or counterparties are required to comply with the regulation, it is highly probable that that firm will also be affected, irrespective of where the firm is located.
To give just one recent example, a DTCC relationship manager recently spoke to a mid-size broker-dealer in South Korea. This firm, which does not have a physical presence in Europe, was confused about why its EU clients were asking about its readiness for MiFID II, including LEI readiness. The firm had not yet responded to its clients, due to lack of preparedness. Hence, it appears that there continues to be varying levels of awareness and understanding about the extra-territorial impact of MiFID II, particularly among firms based in Asia. This is why raising awareness among all market participants of MiFID II’s far-reaching scope is critical if regulatory implementation is to run smoothly in the New Year.
