The Research Commission Battle
So you think MiFID II is just another piece of legislation waiting to be rubber stamped by the European Commission and Parliament? Think again – one the most hotly disputed and potentially high-impact topics for the asset management industry is still very much up for grabs and no one knows the final outcome.
Potentially the result could be the biggest change to the way fund managers and brokers interact– a sort of Big Bang’s Big Brother. Ever since Warren Buffet was wearing short trousers, brokers have tried to differentiate themselves by providing research alongside their trading platform. Fund managers paid commission when they trade which covered the cost of research and the cost of execution. But what if the broker executing the trade didn’t provide research, or at least research that the fund manager found useful? They got paid for research anyway. And what if a broker provided great research but the fund manager doesn’t trade with them? The broker didn’t get paid at all.
Commission Sharing Arrangements (CSAs)
The solution was CSAs. These recognise that trading commission is made up of two components and tries to split, or unbundle them. The broker who gets the trade keeps the commission which has been allocated to execution but has to put the research commission into a CSA account. This commission is then used to pay the providers of research, who may or may not include the executing broker. So the fund manager can give the trade to the broker offering best execution and then use the research commission to pay those who helped them research the trade – so is everyone happy?
The FCA think not. The problem that they see is that if a fund manager trades more, they build up a bigger CSA pot and make more payments for research. However just because they are trading more, it doesn’t mean they have used more research, they might have just got major inflows into some funds. Taken to the extreme, if a fund managers trading doubled, research providers would get twice as much for basically the same level of service and of course commission comes out of client assets. There are ways of controlling the research spend, such as valuing research and switching to execution only rates when there is enough in the CSA pot, however the FCA have not seen sufficient evidence to convince them fund managers take the cost of research seriously. Considering the rules which allowed for the use of CSAs came into effect in 2006, the FCA feel that the industry has had long enough to get its act together.
Execution Only Commission
The FCA see a simple solution to the problem. Commission should be all about trading, not research, therefore it should only cover execution. Research is all about the fund manager trying to find investment ideas, therefore it should be paid by the fund manager. As a slightly diluted model, they would accept fund managers collecting money directly from their clients and using this to pay for research (on the basis fund managers are generating investment ideas on behalf of their clients, not themselves). They feel this transparency would incentivise fund managers to think a bit more about what they are buying and exercise greater control over research spend.
The Future For Research Commission
The problem is some other regulators think that making improvements to the way fund managers operate CSAs would be sufficient - effectively enhanced CSAs. They believe if all fund managers budget properly for research and control the collection of research commission through a CSA, all you are really debating is the collection mechanism.
So what is the future? If the FCA get their way, there are no more CSAs and there will be a major change in how fund managers pay for research. This means that paying for research needs to become highly transparent, and the asset manager can choose to “pay hard” for research themselves, or pass the costs on to their clients in such a way that those clients can very clearly see that it is them, and not their asset manager who is paying for that research. If different asset managers adopt different models, what will clients think when comparing one manager to another?The situation could arise where, the client pays for research themselves through one manager, where for another, the manager is picking up the cost. Those management houses with large internal research teams already invest heavily in their own research, and whilst likely to supplement this with some broker research, they could therefore adopt the “pay hard” model without too much direct financial impact. This will not be so easy for a manager with no internal research capability, who get all their research from brokers, and will therefore find the “pay hard” route a significant hit to their bottom line. They are far more likely to need to pass the cost of research directly on to their clients.
If the more moderate regulators get their way, a less dramatic change will be necessary (assuming a fund manager currently uses CSAs), but the controls and processes needed to run an enhanced CSA will still require a serious overhaul.
Whichever of these apply, one thing is certain, and that is that no longer can execution and research commission be bundled together, and their relative costs hidden. Transparency will be required, and this could mean impact on systems, processes, policies, and monitoring / reporting of such.
So the only certainty is change. The big question is, whatever the final directive, are you ready for it?
If you would like to follow up on this topic, please contact Simon Harris a Director with ISC.