Europe’s regulatory body, ESMA, has finally announced its long-awaited capital market reforms. With a mere 1,500 pages to wade through and just 28 new rules to come to grips with, it’s fair to say that fund managers will have plenty on their plates over the next 15 months.
While many will be thankful for the level of granular detail regarding who needs to report on what to whom and when, the question still remains of exactly how research will be paid for. ESMA is expected to release the final delegated acts in November, clarifying whether commissions will still be allowed as a means of payment for investment research.
Until then, much uncertainty still surrounds how exactly fund managers go about paying for research. There is currently a lack of clarity stemming from national regulators’ differing interpretations of ESMA’s take on Commission Sharing Arrangements (CSAs) – which enable fund managers to access research and execution from separate providers while paying for both through dealing commissions.
One thing we know for sure is that investment managers must set their research budgets in advance either through CSAs or – in the event that the European Commission decides that managers have to pay for research separately- via a Research Payment Account (RPA). Put simply, an RPA would be funded by client assets, agreed and disclosed upfront and based on a research budget that is not linked to execution volume.
ESMA states that research costs should not be linked to the volume or value of execution services. Back in February, the FCA stated that CSAs are linked to transacted volumes and therefore not allowed. Yet other European regulators have argued CSAs will still be valid. The reality is that fund managers cannot afford to wait for the final results on all of this: there are fundamental questions that need addressing today.
The most pressing of these is exactly how fund managers will be affected. If CSAs remain admissible under the new rules, fund size and location will become an important factor. If the cost of research goes up, smaller investment managers may be disadvantaged solely given the relative impact any increased expense would have on a small firm.
Then there is the administrative burden of setting a research budget – deciding how much money to set aside for research will be challenging. As things stand, it is hard to put an exact figure on how much will be required. However, larger players may find it easier as their budgets likely have more capacity to absorb any extra research costs.
As if this wasn’t enough to think about, MiFID II, a European law attempting to increase competition and protection in investment services, now encompasses all asset classes, so confusion also remains over how firms should allocate research payments. For example, can an investment manager who consumes research for currency and bonds share the cost with an equity-focused colleague? If so, how should they allocate the cost? Additionally, fund managers will have to contend with extra expenses if research is unbundled as VAT costs will be piled on top.
One might think that once research has been allocated and costs factored in, fund managers would be all set, but there are other points to consider. Since trading desks will gain greater discretion over which execution brokers to trade through, the quality of algorithmic and electronic trading will become even more important.
It may take a while for this change in approach to gain ground, but time is of the essence for fund managers. The challenge for their trading desks will be to re-evaluate the tools available to them now to ensure they achieve best execution.
What immediate steps should fund managers take to prepare for this new and highly complex environment? Well, unbundling broker relationships to gain transparency and differentiate between execution and research is a good place to start. CSAs can certainly help with this as they are designed to get the best research and execution from separate providers, without incurring additional costs or administration. Fund managers can also compare past research budgets with future expectations, as well as assess whether portfolio managers are consuming all the research they currently receive.
It would be unwise for fund managers to break from CSAs now, as the European Commission comes to a final decision. As far as long-term strategy for research payments is concerned, much will obviously depend on whether the rules are implemented as a regulation or directive. If a regulation, they must be implemented uniformly across Europe. A directive, on the other hand, provides more flexibility to local policymakers and regulators in how they interpret and apply the rules.
Regardless of the outcome, fund managers who are already tackling the key questions will be best positioned to demonstrate full transparency to clients.
Jack Pollina is managing director of broker and financial technology provider ITG.