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06 May 2015

Shaking the structure of financial markets: Unbundling research costs and execution (Part 3)

Talk of Capital Market Union (CMU) is all the rage amongst EU policy-makers at present (if you exclude rage about Greece…) but it is easy to forget that a key building block is already planned to come into force on 3 January 2017.

That is the date when MiFID II /MiFIR become operational – with revolutionary implications for the relationship between investors and traders/issuers of the securities they own.

The integrated investment banks presently offer a set of services in a bundle where the costs are covered by commissions for executing securities transactions. So the costs that investors pay (via their intermediary financial institution) depend first and foremost on the turnover, and then on the price, of the securities traded. So a `bull market’ generates huge transaction fees – irrespective of the value added by the bundle of services. The EU’s regulators seem determined to end a system that costs savers a significant part of the return on their money – and if they are successful, the chances are that the approach will be copied globally.

This approach illustrates the delicate balance that must be struck en route to a CMU that delivers good returns to savers yet provides the incentives for financial markets to provide a wider range of products. Already, securities firms are facing sharply higher capital charges for positon-taking in securities to facilitate client trading, as well as higher costs for non-centrally cleared derivatives.

All this has led to a sharp drop in bond market liquidity. The existing squeeze on equity trading commission has led to a sharp drop in analysts – perhaps halving the number. If CMU succeeds in stimulating a huge wave of securities issuance, who will analyse the prospectuses at issue , and then monitor the financial health of issuers of equites, bonds and specialised securitisations that will range from long-term infrastructure to SME invoice discounting? This is the challenge that must be met by the detailed provisions for implementing Article 24 of MiFID II: “General principles and information to clients” that is included in the category “Provisions to ensure investor protection”.

The European Commission received the draft Technical Advice from ESMA in December 2014 and the Expert Group of the European Securities Committee (EGESC) had a first substantive discussion in January 2015 – publishing a useful summary of the discussions. The subsequent meeting in April began the discussion of possible texts – the key step. Surprisingly in the new age of transparency, the drafts have not been formally published but widely distributed instead, thus confusing the industry about the exact status of them. In turn, that has led to confusion about the current outlook for Commission Sharing Arrangements (CSAs) – the financial mainstay of independent research providers.

Will CSAs be banned? Or phased out as other mechanisms come into operation? How will the investment banks respond in terms of pricing their research? Will investment managers switch quickly to new arrangements?

Perhaps the starting point is to understand how savers’ representatives – the investment managers – may react. Frost Consulting have produced some fascinating analysis that shows pension fund sponsors – a major group of investors – as discharging their duties to their beneficiaries rather poorly. The vast majority of sponsors pay great attention to measuring the impact of execution costs on performance – yet such costs make hardly any impact. However, fewsponsors measure the impact of research costs – yet they constitute the great bulk of the impact on portfolio return!

The crunch for providers of research comes in the draft text of Article 26 (b) of the delegated act. Provision of investment research will not be regarded as an `inducement’ if funded by “direct payments by the investment firm out of its own resources”. Naturally, that could be financed by an increase in the management fees. So the client would know exactly what is happening. 

The other permitted mechanism would be “payments from a separate research payment account controlled by the investment firm”.  However, there are substantial strings attached to this as it would “only be funded by a specific research charge to the client”. That charge would be based upon a “research budget” reflecting the “need” for research for the client AND it “shall not be linked to the volume and/or value of transactions executed on behalf of the client”. The unbundling would be complete.

So far, so good. But how will all this work in practice? A budget must be set with “appropriate controls” and overseen by “senior management” to ensure its use in the “best interests of the clients”. The controls would include regular assessments of the “quality” – based on “robust criteria”.  This will be laid out in a “written policy” that is made available to clients; the budgeted amounts will be provided ex ante to clients and, ex post, an annual statement of costs actually incurred.

The intentions seem excellent but there are enormous numbers of details for the proverbial devil to get into. Then there are competitive risks of predatory pricing during the transition from current CSAs to the new wave of RPAs. Moreover, there needs to be complete clarity as to whether execution payments can be used to `fill’ the RPA before shifting to an execution-only basis once the RPA is full. Can an existing CSA be used up to that point?

Many questions remain to be answered but the unbundling of research costs – and the expected substantial decline in research revenues – is likely to be another nail in the coffin of the `integrated investment bank’ business model. Careful thought must be given to how the expected wave of securities issuance from CMU will actually be organised in a way that genuinely benefits citizen-savers.



Graham Bishop is an independent researcher

and a member  of Euro Independent Research Providers (EuroIRP)


© Graham Bishop

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