Pending European regulation impacting payments for investment research has taken a dramatic new twist in the past couple of weeks. UK regulators recently launched a campaign to interpret the pending language as a ban on using dealing commissions to pay for research. After getting over their initial shock, European market participants are now mobilizing to petition the European Commission directly. The struggle over the final rules has now become a major regulatory brawl involving asset managers, investment banks, independent research firms, and the regulators from the UK, France, and Germany.
The story so far
Even faithful readers of ResearchWatch can be forgiven for getting lost in the maze of European regulation. To recap, the Financial Conduct Authority (FCA), the securities markets regulator in the UK, has become increasingly uncomfortable with the current commissions regime over past two years. Last June it issued new guidelines requiring asset managers to put values on bundled research, prohibiting payment for unused research and banning the payment for corporate access with dealing commissions. One month later it released a discussion paper interpreting pending European regulation as a complete ban on the use of dealing commissions to pay for research, and supported the desirability of such a ban by citing abuses found in an industry review it conducted from November 2013 to February 2014.
The FCA’s aggressive position provoked a massive industry response seeking to influence the language in the next generation of the European Markets in Financial Instruments Directive (MiFID II). The regulatory body responsible for drafting the initial regulatory language, the European Securities and Markets Authority (ESMA), received over 200 comment letters comprising an estimated 10,000 pages of text, much of it focused on the language impacting research payments and most of that negative.
ESMA released its draft language accompanied by explanatory discussion in December and industry participants breathed a collective sigh of relief. The head of the UK trade association for investment managers was quoted in Institutional Investor on January 15th as saying, “The industry asked [ESMA] not to effectively ban the ability for investment managers to be provided with research paid for by clients’ dealing commissions, and ESMA has listened to that request. They have proposed a regime which will allow for client dealing commissions to be the source of payment for research.”
Although ESMA’s draft language imposed very stringent conditions on the ability to pay for research with client commissions, including explicit research budgets and more detailed client notification, an outright ban on the ability to pay for research with trading commissions seemed to be averted. That complacency ended two weeks ago as the FCA began an effort to promote its own interpretation of the draft regulation as in fact banning the ability to pay for research with dealing commissions.
A key part of the argument is whether Commission Sharing Agreements (CSAs) would be permitted under the new regulation. In its explanatory discussion of the new regulation, ESMA seemed to support CSAs: “ESMA has clarified in which circumstances the receipt of research does not qualify as an inducement … and is therefore permissible. In doing so, ESMA has elaborated on the suggestions to allow for commission sharing agreements.” (page 132 of ESMA’s report)
The draft regulation specified modifications, such as budgeting and client notification, seemingly to make CSAs conform to the new guidelines: “ESMA considers that the commission sharing arrangements (CSA’s) have elements that address the conflict of interests between brokers and portfolio managers in respect of research. However, the conditions under which such arrangements are currently operated often do not entirely address the conflicts of interests at stake…ESMA has therefore formulated additional requirements which are aimed at further limiting these conflicts of interest.” (page 133)
The FCA’s view is that the draft regulation does not permit the use of dealing commissions to pay for research. The FCA also objects to having investment banks administer the monies used to pay for research.
The FCA Goes on the Offensive
The FCA has been meeting with various market participants to promote its point of view. Last week it was reportedly represented at a dinner in Brussels attended by asset managers and other European regulators. The FCA repeated their view that research payments could not come from commissions, but must be separately agreed hard dollar amounts paid by the asset owner to the asset manager. The other regulators did not appear to share that view but are said to have been far less organized and forceful in their arguments. The FCA has also been meeting with investment banks, with the Investment Association, which is the trade association for UK investment managers, and with EuroIRP, the trade association for independent research.
Industry participants are pushing back. The CEO of Sanford Bernstein sent a letter to clients urging them to contact their trade association representatives or the European Commission directly with concerns. Asset managers are reportedly telling regulators that the FCA’s interpretation is equivalent to increasing their management fees, which they are not able to do, resulting in reduced profitability, industry consolidation, and migration of assets from European domiciles.
Technically, formal comment on ESMA’s draft language impacting research payments is closed, but the European Commission is reportedly welcoming input from the industry on this topic. The Commission will likely be hearing from the Association of Financial Markets in Europe (AFME), which is the trade association representing European investment banks, the Investment Association and its European counterparts, EuroIRP and others. Reportedly even the regulatory authorities will be lobbying. The FCA is expected to weigh in, as are the French regulators, L’Autorité des Marchés Financiers (AMF), who are very publicly opposed to a ban on paying for research with client commissions. German regulators have been less vocal, but reportedly share similar views to the French.
The European Commission is expected to finalize the rules in June, after which they will be voted on by the European Parliament. Ironically, a UK Member of European Parliament (MEP) has publicly opposed the FCA’s position, stating that “MEPs made it very clear to ESMA that disclosure of the use of commissions is sufficient and banning of commissions should be off the table.”
If the provisions impacting research payments end up as a directive, they will then need to be implemented by each country’s regulator. However, it is possible that the provisions could be drafted as regulation which must be accepted by all EU members and not subject to country-level interpretation.
There is a rumor that the FCA is considering applying for an Article 4 exemption that would allow it to add further provisions to the final language. However, it is also rumored that the Commission is not open to applications on this topic. All of which suggests that this drama could continue even after the Commission finalizes the rules.
Problems with the FCA’s Argument
The FCA’s vision for research payments is, at its best, singularly impractical. Reportedly the FCA is arguing that its interpretation of the ESMA language would create a payment process which is commission-like, allowing investment managers to draw on pools of client money as needed, without negotiation with asset owners. The pooled amounts could be applied across funds and across investment teams as is currently the case with CSAs. The FCA envisions that these commission-like research payments would be separate from management fees, subject to client sign-off if they are to increase but not construed by asset owners as part of the management fees.
There are a number of problems with the FCA’s research payment picture. If research payments are no longer tied to commission payments, then asset managers will have to charge their clients fees for research based on assets under management, which just so happens to be the same way management fees are calculated. It would be perfectly natural for clients to view them similarly, if not identically. Given that the FCA’s declared end-game is to have asset managers pay for research out of their own wallets, its assurances that research payments will be distinct from management fees seem naïve at best.
Further, the payment infrastructure around CSAs has been built over the last nine years. Although asset managers control the payments made through CSAs, the infrastructure has been built by the investment banks not by the asset managers. The FCA’s vision assumes that asset managers can replicate that payment infrastructure in less than two years. Actually it will be less than a year and a half, because the current muddle won’t be clarified until at least June when the final rules are published.
Then there is the issue of ensuring a level playing field for asset managers who play by the FCA’s proposed rules. At the moment, there are a number of European domiciles, such as Spain and Italy, which have not even adopted CSAs. How warmly will those regulators be embracing the FCA’s more arcane approach and how capable will the asset managers in those countries be in implementing it? For that matter, how vigorously would the French enforce regulations which they passionately believe would be detrimental to their financial markets? It is unlikely that even in Europe the FCA’s proposed regime would be universally applied.
If we turn beyond Europe, the FCA’s formulation for research payments actually becomes toxic. If UK asset managers “commission-like” payments are not commissions they cannot be combined with US 28(e) safe harbor assets and need to be quarantined, creating major headaches for global asset managers.
The FCA and its predecessor successfully created a regime which improved commission transparency globally. Even in the US, where the Securities and Exchange Commission did precious little to promote commission transparency, approximately 45% of asset managers have CSAs in place. If research budgeting were implemented through CSAs, as the FCA endorsed as recently as last July, it is likely that the practice would be adopted on a global basis by many asset managers.
In contrast, the FCA’s current position is a prescription for widespread regulatory arbitrage. It is not clear that the FCA’s system of research payments would even be implementable across Europe. It would have no hope of being adopted outside Europe.
For research providers, the consequences of the FCA’s proposed regime would likely result in lower research payments as asset managers and their clients reduced the research-related fees. Both investment banks and independent research providers would be impacted. As we saw during the commission declines after the financial crisis, independent research providers are likely to be disproportionally impacted during large-scale cuts to commissions, as asset managers try to protect their relationships with the larger investment banks.
Nevertheless, before you start to think about shutting down your London offices, keep in mind that this saga is not over. While the FCA has great prestige among European regulators, it may not carry the day in the final MiFID II rules. Stay tuned.