MiFID II’s requirements around research unbundling have attracted much commentary in terms of their impact on both buy and sell-sides. As providers of research services, the obligation to unbundle falls on the sell-side, and as such will trigger significant changes in their operating models.
The impact on the buy-side is potentially just as great. Whereas UK fund managers have long been subject to rules requiring the use of commission sharing agreements (CSAs), the new MiFID II research unbundling rules will go one step further. They demand even greater transparency in the way firms budget and account for research services, as well as much sharper focus on demonstrating the value of those services to investors.
The Key Principles
In its consultation paper CP16/29, the FCA has proposed applying MiFID II research unbundling rules equally across the investment management community. That means collective portfolio management (CPM) firms—including UCITS management companies; full-scope UK AIFMs (alternative investment fund managers); small authorised AIFMs and residual collective investment scheme (CIS) operators; as well as incoming EEA AIFM branches—would all be subject to research unbundling rules.
While the FCA has yet to issue a final policy statement on the topic (expected June 2017), it is important to consider the “key principles” or goals that it is looking to achieve through research unbundling. These are clearly stated in its consultation:
- Investment firms should account for research as a fixed, predictable cost, not linked to execution costs or otherwise subsidised
- The cost of research should either be a core management cost or be fully transparent to investors, thus removing any conflict of interest
- A transparent, priced market should emerge where the cost of research is linked to the quality and quantity of goods and services supplied (and the value derived to investors)
Abiding by those Principles
While the stated principles behind research unbundling may seem fairly straightforward, the path to adherence (to those principles) is anything but.
From the perspective of investment managers, the most pressing priority (should the FCA confirm its current thinking) will be to decide how research will be funded going forward. The choice in this respect will be binary. Either pay for research from your own p&l (from existing or increased management fees for example), or get agreement from clients to set aside a pot of money which could accrue from trading activity —known as a research payment account (RPA)—that can be budgeted, accounted for, allocated and reported on to meet research costs.
Finding a happy medium between those two options may prove difficult. Imagine a scenario where fifty percent of your investor base agree to set aside extra funds for research. In reality, the research purchased with this money is likely to benefit the entire investor base. It would be impossible to strip out the value derived from the research and allocate it exclusively to those that paid for it.
That means investment managers may have to make the choice themselves. Either make it clear that a portion of commissions will be channelled into an RPA —a take it or leave it proposition—or accept that research is a cost of doing business and pay for it themselves.
Determining ‘Quality and Quantity’
Assuming decisions around how to pay for research are resolved, the question then turns to how to maximise the value of research budgets. Simply understanding the different services on offer will be a challenge. As the market for research evolves, it is likely that services will take many different shapes and sizes.
Traditionally, sell-side research has been a multifaceted offering. At its most basic, it offers quantitative and qualitative insights into a given security, sector or broader economic trends. Beyond that, there are numerous other potential services and benefits. Research could be event-driven, focusing on shorter term trading ideas; it could include time with an analyst to help sound out ideas, or access to valuation models including detailed line item projections.
However, in the context of MiFID II, consumers of research will need to dissect previously bundled services using the taxonomy outlined by ESMA. That means understanding which services fall squarely into the ‘research’ category, which could be considered ‘discrete services’ (and need to be billed separately), and which can be classified as minor non-monetary benefits. To qualify as research, the service must: inform views; recommend a strategy; and provide a substantiated opinion, analysis and original insights. This is a high bar requiring a commensurately robust governance process.
Furthermore, the fact that all research services need to be charged for in some capacity means receiving any form of free research will be in contravention of the rules. That places the burden on providers of research to tightly control their distribution policies; while research consumers may need to crank up the spam filters.
The diversity of services on offer also means simple apples-to-apples comparisons and valuations will be difficult. Gauging the quality of research is an imprecise science. Some tools are available to help assess forecasts and recommendations quantitatively – However, as we have mentioned, recommendations and forecasts are only one aspect of research services. Qualitative assessments are therefore vital, and as such, annual rankings such as those compiled by Extel can also be a good guide to market perceptions of quality.
Meanwhile, new initiatives are also being launched that look to fill a gap in the research procurement market. While each has its own nuanced approach, the overall aim of platforms like RSRCHXchange and ERIC (Electronic Research Interchange) will be to create marketplaces where research providers and consumers can transact in compliance with MIFID II. However, while industry tools can be of assistance, subjective decision making will be required to guide future procurement decisions as different managers will value a unique set of attributes and capabilities in their research providers from others.
A Moving Target
As sell-side research embarks on its journey towards a ‘transparent, priced market’ all participants will find themselves facing a steep learning curve. The sell-side will need to work out how to price its unbundled services in a way that makes economic sense. As such, its service offerings and packages will no doubt evolve, as investment firms look to baseline the commercial viability of their research operations.
Meanwhile, the buy-side will need to keep track of the evolving landscape and make purchasing decisions based on which services offer most value to their investment decisions. As the FCA has already stressed in its guidance, this will require an auditable methodology – ensuring procurement of research is well thought through, documented and continues to be optimised.
Just as our previous alert on best execution has highlighted – it will be important that firms adopt a quantitative mindset. However, the ability to quantify all aspects of research provision will not be so straight forward, particularly in less liquid markets. For example, the cost of providing fixed income research until now has typically been contained in the spread charged by dealer banks. Whether unbundling fixed income research results in a tightening of those spreads, a likely outcome in the FCA’s view, will be very difficult to discern, given the range of macro and micro economic factors that may also be in play.
As the moving target unfolds, one thing is for sure: firms will need to do all they can to stay informed – keeping in regular contact with their brokers, industry counterparts and the consultant community to ensure they have the right information on which to base their decisions.