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The inducements of MiFID II

MiFID II's inducement ban could influence competitiveness within the European asset management sector

The European Union's (EU) Markets in Financial Instruments Directive II (MiFID II) introduces a series of new requirements for asset managers, including transaction reporting, greater transparency, robust product governance assessments and tighter supervision of algorithmic and high-frequency traders.1 It is the ban on inducements, however, that is the more controversial requirement.

Key insights

  • Inducement bans will make it more difficult for EU asset managers to obtain research, requiring them to pay directly or implement RPA structures
  • Large asset managers are generally well-resourced and can hire more researchers or pay for research directly with limited disruption to business in contrast to smaller boutique firms
  • Boutiques may be find it necessary to purchase less research, or consider consolidating

The inducement ban applies to sell-side research, which comprises part of the bundled service offering provided by brokers to their asset manager clients. Historically, asset managers paid for research through dealing commissions, a commercial arrangement which regulators, including the United Kingdom's Financial Conduct Authority, have long believed creates a potential conflict of interest risk.

MiFID II, which became effective on January 3, 2018, prescribes the use of dealing commissions by fund managers to purchase sell-side research. Brokers are permitted, by way of exemption, to share short-term market commentary with clients on condition that it provides no monetary benefit.3 Free sell-side research for asset managers is now no longer permitted in Europe. 

MiFID II is leading to new research models 

Unbundling has forced asset managers to reconsider how they procure research, if they do so at all, as some firms have transitioned to execution-only relationships with brokers. One strategy has been to set up ring-fenced Research Payment Accounts (RPAs), which are pre-funded by clients and subject to strict cost transparency requirements.4

RPAs' annual budgets must be fully signed off by clients, and regulators have made it clear that there can be no correlation between the overall research charge and trading volumes.5 The RPA model will require structural adjustments and modifications to existing commission sharing agreements (CSAs), which could be a concern for continental European managers that tend not to operate CSAs.6 The RPA structure permitted under MiFID II is complex, and obtaining client agreement on research budgets could become a protracted exercise. 

Unbundling has forced asset managers to reconsider how they procure research

As a result, firms are opting to pay for research out of pocket rather than adopting the RPA model. Analysis by FTfm revealed that more than 70 percent of asset managers surveyed will absorb research costs into their P&L, absolving clients from any additional charges.7 Several large firms, including Deutsche Bank Asset Management, are developing proprietary research divisions in order to reduce reliance on external providers.

Another cost saving alternative under consideration is the option to discontinue research coverage of small and medium enterprises (SMEs). This approach could influence market liquidity and drive investor relations teams to expand their roles. 

EU regulators are expected to conduct reviews and assess the impact of this aspect of MiFID II in 2018. 

Smaller firms feel the research pinch 

The cost of hiring proprietary research teams or paying for research directly is unlikely to be too disruptive for large asset management houses, but may be more challenging for smaller firms with lower assets under management. Boutique managers are at an impasse as to whether they pay for research and impact overall P&L, or burden clients with higher fees,9 and are questioning the value of some of the research they receive. A Chartered Financial Analyst Institute study stated that 78 percent of firms are likely to source less research as a result of MiFID II.10  

The RPA structure permitted under MiFID II is complex

Experts anticipate that research budgets at UK asset managers will drop from GBP 200 million to around GBP 90 million when unbundling takes shape.11 

The impacts of MiFID II, alongside other costly regulations and requirements, are impacting smaller firms to a greater degree, which could precipitate a drop in new fund launch activity.12 A likely consequence is that these firms may be forced to consolidate to achieve economies of scale.13 

Navigating regulatory arbitrage 

MiFID II is extraterritorial, and some provisions regarding research do not necessarily align with third-country legislation.14 For example, in the United States, MiFID II's research constraints were directly at odds with the US Investment Advisors Act.15 

US law stipulates that any bank selling research “for hard dollars as opposed to soft, indirect payment through trading commissions (must) register as an investment adviser."16 The "investment advisor" label results in impacted organizations being subject to added fiduciary obligations and trading restrictions.17 

In October 2017, the Securities and Exchange Commission issued a no-action relief entitling brokers to receive hard dollar payments from EU money managers while excusing them from investment advisor rules, albeit on a temporary basis.18