Dear Clients and Friends,
Last July we sent out a Client Alert when the FCA released its Discussion Paper DP14/3 entitled “The Use of Dealing Commission Regime” seeking views on proposed further changes to its rules. The FCA has now published Feedback Statement FS15/1 entitled “Discussion on the Use of Dealing Commission Regime” in which it reports on the main issues arising from DP14/3, gives its reaction to ESMA’s MiFID II proposals in this area, and outlines the expected next steps for firms.
The FCA (and its predecessor, the FSA) has been tightening its rules on use of dealing commission since just after the turn of the millennium. Changes limiting the range of goods and services that could be paid for out of dealing commissions were consulted on and implemented between 2003 and 2006, just ahead of the first MiFID legislation which also addressed these issues. Further rule changes took place in 2014 – at the same time as MiFID II and ESMA’s ensuing consultation were proposing stricter rules in this area. The FCA continued to consult on this topic after its amended rules came into force in June 2014. Now these FCA and MiFID II streams have combined in Feedback Statement FS15/1.
The FCA’s feedback statement
The FCA has reiterated its preference for reforms that would bring about a complete separation of payments made by investment managers for the receipt of research from their execution arrangements (“unbundling”). The FCA has, for some time, emphasised its view that investment managers must be able to show that they are acting in their clients’ best interests when using dealing commissions to pay for research and other permitted goods and services. In FS15/1 the FCA unequivocally endorses ESMA’s final proposals to separate portfolio managers' payments for research from execution arrangements. The FCA considers that this will better align managers’ incentives to control costs and procure research in the best interests of their customers.
ESMA's MiFID II proposals
ESMA’s final proposals (in its Technical Advice to the European Commission) significantly change the manner in which investment managers will be permitted to purchase research. This will be permitted only if is paid for either:
- directly by the manager out of its own resources; or
- through a 'research payment account' (“RPA”) funded by a specific, separate charge to its client, which is agreed and disclosed upfront. The charge must be based on a research budget set by the firm and cannot be linked to execution volumes or value (i.e. dealing commissions or spreads).
ESMA also proposes that, in order to further enhance transparency in the use of RPAs, the manager should provide clients with periodic disclosures on the total amount actually charged for research and the manner in which the research payment account has been used.
In order to implement unbundling, ESMA proposes that a broker which provides both execution and research services to a portfolio manager should be required to identify separately the fee for its execution services and for its additional services, such as research. These provisions have caused some confusion about the future for commission sharing arrangements (“CSAs”) (see below).
To ensure a harmonised approach applicable to all investment managers, ESMA also suggests that the final MiFID II requirements should be extended by the European Commission so that they also apply to management activities carried out by managers regulated only under the AIFMD and UCITS Directives. It is highly likely that this will happen at a European level. If not, the FCA will almost certainly add additional rules to ensure a level playing field.
We consider that the two key substantive issues for our clients arising from FS15/1 are the use of CSAs and the application of these changes to the fixed income markets.
The Use of CSAs
ESMA’s position on the CSA model is not entirely clear. It has noted some of the issues with the way in which the CSA model is currently being employed by firms, without ruling an amended CSA model out explicitly as a mechanism compatible with the post MiFID II regime. This lack of certainty has been reflected in the differing interpretations of its proposals that have been arrived at by certain member state regulators other than the FCA. For example, the French regulator, the AMF, appears to see the CSA as being viewed positively by ESMA.
In contrast, the FCA insists that CSA arrangements are incompatible with ESMA’s MiFID II proposals. The FCA’s view is that ESMA wishes to see the link between research payments and execution severed entirely and that this cannot be achieved if the CSA model remains in use. This has led the FCA to view RPAs as a separate and distinct payment mechanism. The FCA clearly expresses its interpretation of the ESMA advice to be an intention to establish a “hard dollar” research market.
The issue of certain of a manager’s clients benefiting from research funded by charges on its other clients would be resolved by establishing a separate RPA for each account, with a pro-rata allocation of cost for items of research which benefit multiple clients pursuing similar strategies.
Application to fixed income markets
FS15/1 confirms what was indicated in the FCA’s Discussion Paper - that the MiFID II reforms are not financial instrument specific, and so fixed income managers will be brought within the regime. Since the charging model of sell side firms in the fixed income markets is not based on commissions, but on bid/offer spreads, the cost of any research provided alongside execution services in these markets is currently priced into the quotes.
The FCA’s view is that, under the new regime, an adjustment will need to be made to the spreads quoted by the sell side (these will likely get narrower to reflect only costs attributable to the execution component of services provided) and a separate discrete charge will need to be levied for any research offered. This will need to be funded from an RPA with budgets pre-agreed with the sell side firm’s clients.
What you should be doing now
The FCA’s message is clear: don’t wait for MiFID II to be implemented in January 2017. Get started now where you are able to identify areas in which your current practices are not in line with the proposals, especially if there is a direct link between trading volumes and research budgets. This will come down to practices such as setting research budgets, assessing research needs and developing valuation methodologies/process against which to judge research obtained.
The FCA’s view, as expressed in FS15/1, is that even though it will only introduce its new regime as part of its MiFID II implementation package some time in 2016, firms should start work on making appropriate amendments to their procedures now, as this will facilitate a smoother transition into the post MiFID II world.
Where firms have affiliates subject to regimes applying different standards to those of the UK and the rest of the EU, including the US soft dollar regime, firms and their affiliates may wish to consider the separation of commission streams.
Please contact Edward Black, James Andrews or your regular ACA consultant with any questions regarding this e-mail.