The FCA has published a consultation paper (CP24/7) on Payment Optionality for Investment Research. This sets out the regulator's considered proposals in the light of one of the recommendations from the Independent Research Review (IRR) – i.e. that buy-side firms should have the option - once again - of being able to buy research on a bundled basis, subject to certain conditions. The MiFID II requirements to separate charges for execution from charges for research were perceived as having had an adverse impact on the provision of investment research in the UK.
- Will this be the return of the "good old days" of bundled payments?
- Who this will be relevant to
- The proposal
- Building the "guardrails"
- Bundling and the US
- Conclusion
- Next steps
Will this be the return of the "good old days" of bundled payments?
It is safe to say, no; and anyway, perhaps memory plays tricks.
The FCA, as with its previous incarnations, has long had a strong antipathy towards the practice of asset managers bundling research charges and execution costs and charging to clients. Even before MiFID II, the regulator's rules and guidance had sought to constrain the practice. In many ways the regulator then helped to lead the charge on introducing the inducement rules under the MiFID II regime under which bundling was effectively outlawed. This left firms with the option of either paying for research out of their own resources or by way of payments from a separate research payment account controlled by them.
In the light of the IRR's recommendations, the government's post-Brexit, Edinburgh Reform agenda of improving UK competitiveness, and the EU's own changes to the MiFID II unbundling regime the FCA has sought strike a balance between the fundamental policy shift that reintroducing bundling into the UK market involves, while ensuring that such reintroduction is nonetheless subject to number of significant protections and conditions proposed by the IRR (possibly with echoes from the regulator's past) in order to obviate "the reappearance of harms that preceded MiFID II".
Who this will be relevant to
From the outset, the changes will primarily be relevant to segregated portfolio managers and some independent investment advisers (and of interest to the asset owner clients of such managers, such as pension schemes). They will not be relevant to adviser arrangers who will either need to continue to pay for bundled research from their balance sheet, or accept it on the basis of having satisfied the quality enhancement test under the inducements rules.
No changes will be made to the "sell-side" rules in COBS 2.3C including the requirement on firms providing execution and research services to price and supply them separately.
The FCA intends to roll out the changes more widely to collective portfolio managers – i.e. AIFMs and UCITS managers – who are currently subject to the same MiFID-derived unbundling rules. However, these will be dealt with in a future consultation.
The proposal
First, it is important to remember that the existing ways of receiving third party research without it constituting a prohibited inducement will remain in place – i.e. managers will still have the option of either paying for the research themselves or establishing and controlling a separate research payment account (RPA), subject to detailed conditions (e.g. as to budgeting, disclosure to clients and governance).
However, under the consultation proposal, firms will in future have a third option. They will be able to receive third party research in return for joint payments for research and execution services without such research constituting an inducement. But, the reappearance of bunding will, not unlike the conditions that attach to the operation of RPAs, be subject to a number of significant "guardrails". These will mean that, even if an asset manager is keen to move to the new bundling model as soon as possible (as some who responded to the FCA's pre-consultation engagement indicated they would be), it will have to undertake a considerable amount of work to make the arrangements work.
Building the "guardrails"
A firm which wishes to avail itself of the "bundling" option will have to comply with a number of requirements or "guardrails", which will require it to establish, document and maintain new policies and procedures:
- A formal policy on joint payments (describing the firm's approach to bundled payments and explaining how the firm's governance, decision-making and controls in respect of third-party research purchased on a bundled basis operate) and a written agreement with research/execution providers (setting out a methodology as to how research costs will be calculated and identified within the total, bundled charges).
- A research provider payment allocation structure (showing the allocation of payments between different research providers (including those providing bundled services and those who are not)) and an approach for allocation (whereby the firm must allocate fairly the costs of research purchased using joint payments between clients, taking into account things like cross-subsidisation). This could be a headache for some firms: for the purposes of the costs allocation requirement, draft FCA guidance says that the approach adopted by firms "should be reasonable and its outcome fair across all clients". While this is entirely unobjectionable in principle, it could prove problematic in practice.
- Operational procedures for the administration of accounts used for purchasing research – among other things, this will require managers to establish how they will be responsible for the administration of such accounts, and how they will ensure that research providers receive payment on a timely basis.
- A budget for the purchase of research using joint payments (reviewed at least annually (with a statement in the policy (see above) as to what happens if charges exceed that budget)) and firms will have to conduct a periodic assessment of value, quality and use of research at least annually.
- Disclosure to clients– firms will have to disclose to relevant clients their use of bundled payments for research, the key features of the firm's policy on joint payments, the expected annual costs to the client (to be included as part of the existing requirements on ex ante costs and charges disclosures), an indication of the most significant research providers and the total costs incurred by the client. So some significant "papering" will be required for those firms which decide to switch to the new model.
Bundling and the US
In the US, bundling and the use of so-called "soft commission" arrangements is common. Commission sharing arrangements allow asset managers to pay broker-dealers a bundled rate for trade execution, while having a portion of the commission allocated for research to be purchased from a third-party broker dealer or an independent research provider.
Because of a complication in the US Investment Advisers Act of 1940, US broker dealers are required to register as investment advisers if they intend to accept payment for research separate from execution commissions. With the onset of the MiFID II inducement and research rules in 2017 this presented a problem for EU-based asset managers seeking execution and research from the US since the MiFID II requirements required them to ask for unbundling but a number of US broker-dealers were reluctant to obtain "dual registration" in order to accept unbundled payments. This conflict between the EU and US rules was temporarily fixed by a "no action letter" issued by the US Securities and Exchange Commission (SEC) in October 2017. The letter enabled broker-dealers to receive unbundled payments for research services (constituting "investment advice" under the Investment Advisers Act 1940) without requiring registration. The letter was extended on 4 November 2019, but expired on 3 July 2023.
In certain circumstances, and without the benefit of the "no action letter", broker-dealers may have to provide certain types of short-term trading commentary alongside their execution services but may not be able to receive unbundled payments. Going forward, of course, this would not be a problem for those UK firms that choose to adopt the new, bundled payments option. However, this would be to the relative disadvantage of those firms that choose to retain the existing options (i.e. operation of an RPA or payment from own resources) since both of these require unbundling.
To fix this discrepancy, the FCA proposes – as an additional amendment beyond the IRR proposals – to add to the list of acceptable minor non-monetary benefits "short-term trading commentary that does not contain substantive analysis, and bespoke trade advisory services intrinsically linked to the execution of a transaction in financial instruments". While the commentary makes it clear that this drafting is intended to address the specific US broker-dealer/trading issue raised, in the absence of any Glossary definition, the phrase "bespoke trade advisory services intrinsically linked to the execution of a transaction" would need to be interpreted rather more broadly than the words obviously allow.
Whether the proposed bundled payments option solves a live, widespread problem for firms sourcing US/global research remains to be seen. The consultation paper itself acknowledges that, while the SEC relief expired in July 2023, "evidence of any negative impacts on UK asset managers is limited". Some managers may have established workable ways of receiving third-party research in compliance with the existing rules (e.g. within their buy-side group) meaning that moving to a bundled model may not be commercially necessary.
Conclusion
There was a time when many asset managers would have called in earnest for the return of bundling. Now, after years of the MiFID II regime, things may not be quite so straightforward, although the development is undoubtedly welcome. Those firms which have been paying for research out of their own resources (whether or not that affects the "headline rate") will need to ask themselves whether it makes commercial sense to start charging clients for research again and complying with a new set of guardrails. And those firms which have been operating RPAs will need to conduct a cost benefits analysis between the conditions attached to such accounts against the new guardrails to determine whether unpicking the existing arrangements and setting up the new ones will be worth it. Finally, as referred to above, arrangements under which firms obtain third-party research in compliance with the rules (e.g. where it is procured by a group-affiliated manager in a third country without order routing decisions/costs of execution being affected) will not be affected and so relevant firms will likely think twice about making changes.
Next steps
The consultation closes on 5 June 2024. Ambitiously, the FCA says that, if it decides to go ahead with the unbundling proposal having considered industry responses, it will aim to publish final rules and/or guidance in a policy statement "in the first half of 2024". It remains to be seen whether it will be able to stick to that timetable.
Industry associations will no doubt wish to respond to the consultation: it is likely that they will welcome the proposal in principle but will want to query the practicality of some of the guardrails.
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