On 7 April 2016 the European Commission (“EC”) published its final proposals on certain investor protection measures under MiFID II, including the much debated inducements rules and permitted ways to pay for research through dealing commissions. In this paper, the latest in our series MiFID II: understanding and practical preparation, we examine the details of the reforms, as well as taking the opportunity to update our clients on the revised MiFID II timetable, and some recent push-back from the EC in relation to the European Securities and Markets Authority’s (“ESMA”) proposals in certain key areas.
On 10 February, the EC announced its proposal to put back the go-live date for MiFID II by one year to 3 January 2018. This delay, now confirmed by the European Parliament, was caused by the complex technical infrastructure that ESMA and national regulators will need to implement to make the reforms work effectively. This announcement had been long anticipated and was generally welcomed by the industry. The deadline for Member States to transpose the Directive into their own rule books has also been postponed by twelve months until 3 July 2017.
Final rules on inducements in relation to research
These final EC rules on inducements broadly confirm the political compromise on paying for research through dealing commissions that was leaked to the industry back in December 2015. The exact wording of the critical text1 has been re-ordered but otherwise there have been no substantive changes. Rather tellingly, these implementing measures come in the form of a Commission Delegated Directive, thus leaving some scope for interpretation by national regulators, and this is emphasised by the phrasing “Member States shall ensure that…” at the start of each section. This is perhaps ironic in view of the lengthy period of negotiation that was required to achieve the current settlement.
Is research an inducement?
The EC has apparently ignored the letter it received last autumn from the French, German and UK governments which questioned the treatment of investment research as an inducement to asset managers. Instead, it confirms the approach taken by ESMA in its Technical Advice, namely that substantive research services can only not be an inducement (and hence allowed) if they have been paid for:
- either directly by the firm out of their own resources; or
- from a separate Research Payment Account (“RPA”) controlled by the firm.
The RPA must be funded by a specific research charge to each client of the firm. The amount of funding must be determined by a research budget which must be set and regularly re-assessed in line with the perceived need for research. The firm must also make regular formal assessments on the quality of research received and whether it has actually contributed to better investment decisions.
In line with the Financial Conduct Authority’s (“FCA”) declared emphasis on firms treating client money as if it were their own, the Directive sets out prescriptive requirements for firms to be fully transparent with both clients and regulators about RPA arrangements. At the start of a client relationship (either in the investment management agreement or terms and conditions) firms must state the amount of research spend that has been budgeted for the RPA for each client, and this must be carried forward on an annual basis.
Firms must provide clients with a written policy about these arrangements, including its assessment of the research requirements appropriate to the particular investment strategy of each client, and how the firm will allocate such costs fairly between multiple clients with different strategies, where applicable.
Clients and regulators are also permitted to request additional information about the RPA, including a summary of the research providers paid for out of the account, the total amount they were paid over a defined period, the benefits and services received by the firm and any rebates or carry over of funds from one period to the next arising from the budget not having been fully spent.
Can the research charge be collected through commissions and/or a CSA?
As foreshadowed in the leaked draft, the controversial question on Commission Sharing Agreements (“CSA”) has been settled by a delicate political compromise: the specific research charge to each client must be based on the research budget as established by the stated need and must not be linked to the value or volume of transactions. However, the text does allow for an operational arrangement whereby a research charge is collected alongside a transaction commission – in other words a “research commission”, although this term is not actually used.
As the Alternative Investment Management Association (“AIMA”) pointed out earlier this year, this points to an agreed budget for research which is funded by dealing commission (in a CSA-type arrangement), but with a mechanism to move to execution-only commission rates once the budgeted research charge has been funded. It should be emphasised however that a simple CSA will no longer work: the “enhanced CSA” must include this mechanism to prevent the amount collected exceeding the agreed budget (indeed, many CSAs already contain this provision).
Looked at another way: paying for research through dealing commissions, without some sort of “arrangement” in place between manager and broker, would appear to be problematic. Therefore, either way, the enhanced CSA model may well be the way forward for most situations.
Are there other conditions around the RPA?
Yes, the text sets out detailed requirements around the governance and oversight of such arrangements. The setting of the research budget must be managed solely by the firm and be subject to appropriate senior management oversight (for example, through a “Broker Committee”). There must be a clear audit trail of payments to providers and how such amounts are paid in relation to the required quality criteria. Budgets can only be increased after the provision of information to clients about why such an increase is necessary.
Can I delegate these arrangements?
Yes, you can in terms of the administration of the RPA (but not setting of research budgets). The text specifically allows for this and we expect that this will be an attractive option for many managers.
What about the sell-side?
Investment managers often view sell-side firms as part of the problem in respect of their reluctance to unbundle dealing commissions and the full range of their research offerings to clients. The Directive specifically addresses one part of this by requiring investment firms providing execution services (to EU investment firms) to split dealing charges/commissions into “execution” and “other benefits or services” (including research). It remains to be seen exactly how sell-side firms will address this requirement.
Will the FCA gold plate these restrictions?
In its early responses to ESMA’s Technical Advice on this issue, the FCA clearly stated that it viewed CSAs as incompatible with the stated requirement that research payments are not linked to execution volumes. As we have seen, the final text does appear to allow for a CSA-type arrangement, although it takes care not to actually use that term. In the past, this would point to the FCA gold plating on this issue with a much more explicit restriction in its Conduct of Business rules. This is still possible but, in our view, less likely given the FCA’s recent shift to a more industry-friendly approach.
The EC orders rethink on other MiFID II reforms
In March, the Directorate-General for Financial Services at the EC wrote letters to ESMA asking it to look again at three aspects of their final Technical Standards:
- Bond transparency:responding to concerns about the impact of ESMA’s proposals, the EC has recommended a four year phase-in both in relation to determining whether a particular bond is “liquid” (as defined by the number of trades per day) and in the setting of size thresholds for establishing waivers for “large” transactions. In each case, ESMA will not be allowed to move to the next level of calibration if trading volumes have declined during the preceding period.
- Commodity derivatives positions:the EC proposes lower position limits in some agricultural commodities to take account of the high volatility of such instruments. It also proposes greater flexibility in the use of open interest as a parameter to set limits in contract months other than the one closest to expiry. And it proposes an expansion of the definition of Economically Equivalent OTC contracts which must also be subject to position limits.
- Ancillary activities:the EC proposes changes to the market share and main business tests that determine whether an activity is ancillary to a firm trading commodity derivatives. In carefully worded responses to the EC, ESMA noted that these letters effectively endorsed all its other proposals. This appears to be a signal that ESMA would like to see its Technical Standards in force as soon as possible so that both it and the industry can start adopting practical implementation measures.
The Directive on investor protection measures is but the first of the anticipated Delegated Acts from the EC which will propose its so-called Level 2 implementing measures on a wide range of organisational and conduct of business issues. These measures were originally due in the summer of 2015, but it would appear that these are at last coming through the European pipeline. Unlike the special case of inducements, we expect these measures will come in the form of Regulations, with direct force across the EU. All these measures are also subject to final ratification by the European Parliament and Council.
1Article 13, Inducements in relation to research