The Financial Conduct Authority's (FCA) review into the effects of the research reforms under the second Markets in Financial Instruments Directive (MiFID II) will look to gauge the investment industry's compliance with the new regime and put the definition of inducement on a firmer footing. Asset managers must be prepared for tough questions about their relationships with research providers and their investors' best interests.
Sliding research costs, vague guidelines prompt FCA action
Under MiFID II, asset managers must unbundle research costs from trading commissions to give investors greater transparency. While welcomed by investors, market participants have complained of a lack of clarity as to how much research can still be offered to clients, and at what cost, without being seen as an inducement to trade.1
Key insights
- FCA probe to put onus on asset managers to show they are not being induced to trade by provision of research
- Specialist research providers hope the FCA can clarify inducement rules as larger rivals offer sharp discounts
- Broker scoring processes may be in conflict with new rules, market participants say
Heavy discounts offered by banks and large brokers have also raised concerns that cheap research could itself be used as an inducement to trade, while harming smaller specialist firms unable to compete on price. The FCA's probe will involve surveying asset managers, investment banks, specialist brokers and independent providers on research pricing models. It will also gauge how firms have handled the compliance challenges, and whether they have embedded the right governance and controls.2
Inducement rules put platform services under microscope
The FCA is expected to address a number of potential conflicts that arise from research payment arrangements. One area of concern is the provision of platform services, including Transfer Value Analysis tools and other transfer analysis software for pensions.
The FCA has indicated that such services could be considered as inducements under MiFID II if offered for free, prompting a number of providers to stop offering the reports or introduce charges. The low prices for these reports, which can be as low as GBP 75, have raised queries as to whether they are being sold for less than the cost of producing them.3
Asset managers are being encouraged to use the probe as motivation to re-assess how they have interpreted the rules and apply them in their operations
The FCA has also expressed concern that investment managers may be passing on costs for “add-ons" to clients through platform charges that may not actually benefit them, and could also constitute inducements. “Some of these services are likely to be so-called non-monetary benefits, so they are likely to be caught by our inducement rules," the FCA said in a report.4
Broker scoring seen in conflict with rules
Industry participants have noted a discrepancy in the application of the research rules between providers and asset managers, with independent research firms complaining that investment banks and large brokers are using loss-leading pricing to retain brokerage business. The European Association of Independent Research Providers described the practice in a recent members' survey as “subverting and restricting a true level playing field."5 It further stated: “This is not in the main due to regulatory failings, nor to the attitude or activities of asset managers."
Industry participants have noted a discrepancy in the application of the research rules between providers and asset managers, with independent research firms complaining that investment banks and large brokers are using loss-leading pricing to retain brokerage business
Asset managers have not escaped the scrutiny, however, with boutique research firms querying the use of broker voting systems to determine the allocation of research budgets. Such systems score brokers and providers on the services they deliver, such as research conferences, corporate access, liquidity and algorithms, rather than just the research itself. “Rewarding for research services on an ex-post, rather than ex-ante basis seems very similar to the process pre-MiFID ll," said Chris Turnbull, co-founder of research platform Electronic Research Interchange. “This is in direct conflict with the aims of the regulations and unlikely to change without the influence of the regulator."6
Fund managers must be ready to demonstrate value of research to investors
The FCA probe will evaluate buy-side system and controls along with sell-side pricing models and commercials as the regulator looks to take a multi-firm approach.7 The scope of the review will also take in investment managers' assessments of what constitutes substantive research, the research budgeting process and the governance of Research Payment Accounts (RPA).8 Asset managers are being encouraged to use the probe as motivation to re-assess how they have interpreted the rules and apply them in their operations.
The first question for investment firms to consider is whether they are accepting research on terms which could still be considered an inducement.9 When operating RPA accounts, they must also be able to show how the value gained from research is measured and quantified, and also demonstrate that clients have given their consent to their arrangements.10
One area that may be less clear-cut is the requirement to distinguish between research which is deemed to be “substantive", and must be paid for, versus information that only provides a “minor non-monetary benefit" and can be provided and accepted for free. Asset managers have complained it is a grey area that requires more clarification from the regulator.11
“This is just one example of a grey area that has led asset managers to question how they can undertake an accurate assessment of their research usage," said Emma Margetts, head of European operations at research provider Visible Alpha.12