The Securities and Exchange Commission is attempting to ease some of the pain felt by U.S.broker-dealers and money managers affected by a slate of fast-approaching European regulations.
On Oct 26, following consultation with European authorities, and in response to concerns that investors could lose access to valuable research, SEC staff issued three no-action letters. They are designed to provide market participants with greater certainty regarding their U.S. regulated activities as they engage in efforts to comply with the European Union’s Markets in Financial Instruments Directive, better known as MiFID II, in advance of the Jan. 3, 2018, implementation date.
Although the reach of the rule is focused on trading, investing, and hedging in the European Union, U.S. firms will feel the effects.
MiFID II aims to improve upon the previous iteration of the Markets in Financial Instruments Directive by ensuring that trading takes place on regulated platforms; introducing rules on high-frequency trading; improving the transparency and oversight of financial markets; addressing the issue of price volatility in commodity derivatives markets; and strengthening the protection of investors.
Among the concerns for U.S. firms is that transaction reporting requirements have changed a lot since the original regulatory package. MiFID II requires that asset managers separate trading commissions from investment research payments, establishing a research payment account.
The SEC’s newly announced no-action relief provides a path for market participants to comply with the research requirements of MiFID II in a manner that is consistent with the U.S. federal securities laws.
Specifically, and subject to various terms and conditions: broker-dealers, on a temporary basis, may receive research payments from money managers in hard dollars or from advisory clients' research payment accounts; money managers may continue to aggregate orders for mutual funds and other clients; and money managers may continue to rely on an existing safe harbor when paying broker-dealers for research and brokerage.
“[The]no-action relief was designed with input from a range of market participants to reduce confusion and operational difficulties that might arise in the transition to MiFID II's research provisions,” SEC Chairman Jay Clayton said in a statement. “Staff's letters take a measured approach in an area where the EU has mandated a change in the scope of accepted practice, and accommodate that change without substantially altering the U.S. regulatory approach. These steps should preserve investor access to research in the near term, during which the Commission can assess the need for any further action.”
In a statement, SEC Commissioner Kara Stein said that bundling of payments is a common practice in the U.S. and Europe’s new approach creates a conflict for certain global firms.
“Questions about transparency and investor protection are central to this conflict,” she said. “When payments for research and trading are combined, do investors know that they are paying for research? Do investors know what they are paying for trading? Do investors know of the potential conflicts of bundled payments?”
“The staff’s no-action relief does not adequately address these issues and merely kicks the can down the road,” Stein said, “This inaction may be costly to investors and advantage some market participants over others. While a time-limited approach may allow the staff to study the impact of MiFID II, taking over 900 days is simply unreasonable.”
Anticipated and appreciated relief
The news was welcomed by many of those caught up in the international rulemaking.
“The three no-action letters… will enable some U.S. registered broker-dealers and money managers to breathe a sigh of relief when it comes to managing the unbundling of research,” says Patrick Shea, head of global compliance at Cordium, a provider of governance, risk and compliance services. “Although the investment management industry expected that the relief would come, the release of the no-action letters provides certainty as firms with US regulated activities and an EU nexus confirm MiFID II readiness.”
“MiFID II is a complex piece of regulation with a broad scope, and firms must ensure that they have closely explored all aspects and assessed relevant impact to feel confident that they will be compliant come Jan. 3,” he added.
The SEC’s relief on unbundling “will be helpful in reducing potential complexity in pricing models, especially important as negotiations continue to drag on with many investment firms pushing hard on pricing,” says Michael Turner, a partner in law firm Oliver Wyman’s corporate and institutional banking division.
Turner delved into MiFid II’s unbundling dilemma in a recent client alert. Requiring research to be priced separately from execution “represents a major shift from today’s practice whereby research is supplied as part of a bundle of services, with no explicit charge,” he wrote.
Over time this regulatory change is also likely to have strategic implications, Turner added.
“The total amount of research consumed is likely to fall, and who bears the current $5 billion cost of research is also likely to change,” he wrote. “The suppliers and providers of research must be prepared to respond to a market that is likely to adapt rapidly over 2018, and may move towards a competitive structure that is both more concentrated and more heterogeneous.”
Oliver Wyman estimates a combined reduction of spending on research and execution of approximately $1.5 billion, potentially rising to $3 billion “if a full-blown price war emerges, with the greatest impact felt by lower-quality research providers.”
Research unbundling comes at a time of heightened pressure on investment manager fee structures, with many managers looking to build scale and drive cost efficiencies, Turner noted. Research providers and investment managers expect to see a reduction of between 10-30 percent in research spend, with some as high as 50 percent.
The sell-side “may be experiencing an emperor’s new clothes moment, when the actual value of their research is much less than they have previously been able to allocate,” says Robert Powell, director of Compliance at IPC Systems, a technology provider for financial companies. “Many research houses that started with plans about how much they would charge for access and individual research have adjusted their pricing downwards.
“The buy-side is more worried about inducements,” he adds. “The regulators are really trying to stop anything that looks like a bribe to trade. Golf days and sporting event tickets are a thing of the past. Even lunches are coming under scrutiny from the regulator.”
The no-action letters may be found here, here, and here.
The SEC’s Division of Investment Management provided temporary relief for 30 months from MiFID II's implementation date under the Investment Advisers Act of 1940 to permit a broker-dealer to receive payments in hard dollars or through MiFID-governed research payment accounts from MiFID-affected clients without being considered an investment adviser.
SEC staff will continue to monitor and assess the impact of MiFID II's requirements on the research marketplace and affected participants to ascertain whether more tailored or different action, including rulemaking, is necessary and appropriate in the public interest.
The Division of Investment Management also provided relief under the Investment Company Act and the Advisers Act to permit investment advisers to continue to aggregate client orders for purchases and sales of securities, where some clients may pay different amounts for research because of MiFID II requirements, but all clients will continue to receive the same average price for the security and execution costs.
This relief “provides clarity and consistency to investment advisers by permitting the continued aggregation of orders while addressing the differing arrangements regarding the payment for research that will be required by MiFID II,” the SEC said.
The Exchange Act Section 28(e) safe harbor addresses the manner in which a money manager can use client commissions to purchase "brokerage and research services" without breaching its fiduciary duty.
In the U.S., money managers often use client commission arrangements to obtain brokerage and research services from a broker-dealer, using a single, "bundled" commission that is separated after execution to pay for order execution and research.
Under MiFID II, money managers may make payments to an executing broker-dealer out of client assets for research alongside payments for order execution, and the executing broker-dealer must transmit the payments for research into research payment accounts (RPAs).
The Division of Trading and Markets provided relief to allow money managers to operate within the safe harbor if the money manager makes payments for research to an executing broker-dealer out of client assets alongside payments for execution through the use of an RPA that conforms to the requirements for RPAs in MiFID II, and the executing broker-dealer is legally obligated to pay for the research, provided that all other applicable conditions of Section 28(e) are met.