Facing up to wholesale changes

The wholesale sector is grappling with new rules on inducements and dealing commission. Have firms woken up to the full implications of guidance from UK and European authorities, and what steps can they take to comply?

It has proved a particularly challenging year on the compliance front for the wholesale sector, with firms having to get to grips with new rules on inducements and the use of dealing commission.

The FCA has looked closely at the controls that investment managers have over the use of dealing commissions for the purchase of research. The regulator felt that many financial services firms do not apply a sufficient level of control and oversight on research spending from dealing commission, and therefore need to improve their controls. As a result, the FCA introduced a new set of rules and guidance on the use of dealing commission that came into effect on 2 June this year. 
"Firms should consider undertaking a gap analysis which would benchmark their existing controls against those listed by the FCA" "The FCA has concluded that unbundling research from dealing commission would be the most effective way to manage any conflicts of interest that arise where brokerage costs fund external research," says Henrietta de Salis, Consultant in financial services regulation at commercial law firm Herbert Smith Freehills. "Their objective is to ensure value for money is achieved by investment managers for their underlying investors.

"The FCA recognises that there is a lack of price transparency for research. Nevertheless, it clearly believes firms should be taking action now to improve their processes."

Improving governance
So what has been the response from firms to the FCA guidance?

The FCA's review of wholesale firms, including investment managers, brokers, independent research firms and corporate issuers, found that some have improved their governance over how they purchase research with dealing commissions. However, only a few are applying sufficient rigour in assessing the value of the research services received -- with even fewer operating at the level the FCA would expect.

The FCA did find plenty of examples of good practice by firms in the use of dealing commission. This included independent assessment of the value of research away from investment process, benchmarking where possible to priced research services and setting a research budget. There was also evidence of the use of commission-sharing arrangements to control spend, as well as a broker vote influenced by an assessment of the value of research used by an investment manager. 

The number of pages of responses ESMA has received on its MiFID II proposals
But the review uncovered many examples of bad practice, too. These include the amount paid for research being linked to trading volumes, references to historical spend, and research paid for regardless as to whether that research formed part of the investment decision. The FCA also found examples of firms paying for services - such as market data services bundled with research - out of dealing commission that were not research.

There were firms, too, trading predominantly at bundled rates without using a commission-sharing arrangement, as well as an arbitrary, notional split of a bundled dealing commission rate into execution and research merely for disclosure purposes. Reliance on the broker voting process without assessing monetary value of research received was also in evidence.

Robust set of controls So what steps should wholesale firms and investment managers be taking? The FCA sets out what it describes as a "fairly robust set of controls over the amounts spent through dealing commissions on research, and, to some extent, place a value on specific research goods and services received". These controls are:

1. Separate internal governance and decision-making processes to assess research needs and identifying which providers can provide the services at the best price, and making that decision separate from the decision over where to direct trades.

2. Setting a research budget not influenced by trading volumes and managing this by the use of CSAs, and by moving to execution rates (rather than bundled rates) with a broker once any research cap has been reached.

3. Not rewarding research that does not add value even if supplied.

4. Seeking a specific price for research as far as possible.

5. Broker voting processes that ascribe a clear monetary value to each vote. 

"Firms should consider undertaking a gap analysis which would benchmark their existing controls against those listed by the FCA and take appropriate steps to introduce the necessary tools to address any weaknesses identified," suggests de Salis.

The FCA commented that better disclosure to customers would not necessarily be sufficient to mitigate any conflicts arising from the use of dealing commission to acquire external research. Firms should still be applying the same degree of rigour in spending dealing commission as a firm would apply to spending its own money.

The proposals impact many asset classes. One broker we spoke to commented: "All the talk has been about equities, and any solution proposed by the European Securities and Markets Authority (ESMA) and the FCA should specifically address the situation in the fixed-income and exchange-traded fund markets as these are within scope."

Minor benefitsThe wholesale sector is still digesting the implications of the second Markets in Financial Instruments Directive (MiFID II) and guidance from ESMA on it.

As it stands MiFID II (which is expected to come into force in 2016 or 2017) will prevent portfolio managers from receiving any third-party inducements, with a limited exception for minor non-monetary benefits. The ESMA consultation paper that proposes advice to the EC on the detailed rules that will implement MiFID II discusses the meaning of 'minor non-monetary benefits'. ESMA considers that this should be narrowly construed so that only very generic, widely distributed financial research will be considered as a minor non-monetary benefit.

"If this interpretation is adopted, the FCA believes this would require the unbundling of most research from dealing commission arrangements," says De Salis.

The FCA expects to provide further feedback once it has had an opportunity to review the development of MiFID II following ESMA's consultation. This is expected towards the end of 2014 or early 2015. But according to de Salis, it is clear from the industry's response to the consultation that investment managers do not consider that research should be treated as an inducement, but should be acceptable as a minor non-monetary benefit.

David Lawton, Director of Markets, FCA, notes that MiFID II takes steps to remove the incentives on asset managers that could influence their decisions to trade, against the interest of their clients, when purchasing research from pots of money generated by that trading. "We know this is a hot-button topic for some," acknowledges Lawton.

"ESMA's proposal, as it stands, would lead to a market in which all valuable research - for example, that which is not generic and widely distributed - must be paid for by fund managers themselves, rather than paid unseen by their clients within transaction fees. ESMA is aware of the challenge of removing such incentives which work against investors' interests in a way which avoids unintended consequences."

Lawton explains why the FCA supports ESMA's proposal. "The FCA believes that a more effective market for research and a more efficient asset management sector will develop if dealing commissions are not used to fund these goods and services," he says.

Business expenseThe European Association of Independent Research Providers (Euro IRP), however, has voiced concerns over what ESMA is proposing in relation to MiFID II and dealing commission.

"The risk is that with the loss of commissions being permitted to pay for research, whatever pricing structure emerges in the near future for research paid via dealing commissions, this structure may prove invalid post-2016 if fund managers then have to pay for research as a direct business expense," states Euro IRP. "That development may prove particularly difficult for the independent research sector."

The proposals by ESMA and the FCA have generated considerable debate in both the asset management, broker-dealer and trade-body communities across Europe, with ESMA receiving almost 20,000 pages of responses to its proposals. Respondents, representing both the buy and sell sides, focused on the potential for the changes to result in reduced research coverage, poorer price formation, reduced liquidity in small and medium cap stocks and raised barriers to entry for new entrants. They also highlighted concerns that unilateral change in Europe or the UK would create a competitive disadvantage and regulatory arbitrage. ESMA is due to publish its findings by mid-December 2014.

Yet Michael Harris, a funds associate at law firm Charles Russell in London, emphasises that new rules on dealing commission do not stand in the way of firms making profits. "The aim is not to stop firms making money - and in most circumstances firms can still charge providers," says Harris. "What is certain, though, is that these charges should relate to something and ultimately result in retail clients receiving a benefit."
Published: 16 Oct 2014
  • Features
  • The Review
  • retail investment products
  • Mifid II
  • FCA
  • dealing commission

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