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Research Payments under MiFID II: Is there no such thing as a free lunch? (Part Two)

13 July 2018 Francis Land

In my previous post I discussed the state of play with payments for research a full six months into the reality of MiFID II. I believe that we should consider a potential unintended consequence of the rules, the potential for cross-subsidisation of payments for research in execution trade commissions.

Since January 2018 asset management firms should only pay a broker using trading commissions for trade execution services. Payments for research using commissions should be via a segregated Research Payment Account, be budgeted in advance in the form of a monetary amount and not be determined as a basis points charge against trading costs.

Asset management firms who believe they are MiFID II-compliant in research payments will have put in place the systems and structures to ensure that the trading desk alone decides on when, where and at what cost to execute trades. Separately, investment professionals should exclusively determine value and pricing of research services.

While those processes may be built with the best of intentions and are seemingly robust, there are risks. The reality of the industry in 2018 is that the largest providers of trade execution services are also the largest providers of research services. Optimistically, I believe that MiFID II will contribute a landscape where specialist, high quality providers of trading services and counterparts in the research services area will flourish in the future. But for now, the dominant players remain the global investment banks who have businesses in both trading services and research services and the resources to provide those services.

Towards the end of 2017 the industry scrambled to tie up agreements for the cost of research services post MiFID II. This was a significant new challenge for all parties; from decades of "bundled" commissions paying for research and execution services (with some use of commission sharing arrangements (CSAs)", to a wholly "unbundled" model with separate pricing and payment models for execution and research.

We heard of wildly differing prices as research providers tried to agree research pricing with customers, from low tens of thousands for basic level service access, to hundreds of thousands per annum for equivalent services. Eventually a small number of firms decided to make their core fixed income research "free to all". Others argued that this was against the "spirit" of the rules.

The higher prices quoted by some firms started to come down towards the end of 2017, then in some cases "crashed" by the new year. Some asset managers started to push back, looking in fact to pay more for valuable service. Their concern was that regulators would consider the fees for research too low and wonder if the costs of research were being subsidised by other business transacted with the research providers, including potentially an "inducement" to trade.

The subject of research price "discovery" was and is still arguably one of the hardest parts of MiFID II for the industry to tackle. Some asset management firms acted as "price setters" (determining prices using their own methodology, for example interaction rate cards), others as "price takers" waiting for pricing models to be supplied by the research providers. It should be hoped that the forthcoming FCA review[1] will provide more guidance for the industry to enable more long-term consistency in pricing across the research market.

The FCA will start to contact firms to gather evidence and examine procedures in coming weeks. Our expectation is they will want to ensure that the research pricing model is sustainable. At IHS Markit we see asset management firms utilising our proprietary systems to evaluate and ensure best practice in quality and cost of both trade execution and research services. To us this is strong evidence of asset management firms wanting to pay a fair and sustainable price for a good quality product, whether they are using commissions or their own money to pay for those services. We will monitor the events of the next few months with great interest.

[1]The FCA's review of research payments under MiFID II: what we can expect[Updated 11 September 2018]

In my blog above I referenced the upcoming review by the Financial Conduct Authority into the research payments under the MiFID II. I have been following up on this and I understand that, for their forthcoming review, the FCA will:

  • Consult with approximately 30 buyside firms
  • Request pre-and post MiFID II data on (among other things):
    • Execution commission levels
    • Research costs
    • Number of counterparties
    • Internal analyst budgets
  • Ask about treatment of corporate access events
  • Request samples of pricing models arranged with brokers and independent research providers
  • Look into coverage of stocks especially any adverse impact on small and medium companies
  • Compare continued use of commissions ("RPA") versus use of own money ("P&L")
  • Arrange visits with 10 or so firms

Rather than having pre-determined views on what research should "cost", my sense is that the FCA will want to see firms making "reasonable judgments" utilizing their own requirements and experience.

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