Written by Robert Quinn
Founder and CEO
On 10 April 2024, the FCA published its long awaited proposal for reforming the UK’s investment research regime. The significance to the industry of this particular initiative is signposted in the consultation which boasts a foreword from none other than Nikhil Rathi, the FCA’s Chief Executive.
At a very high level, the proposal introduces a ‘third option’ for the consumption of research. In addition to paying separately for research, either by the firm itself or by the firm’s clients via research payment accounts, for the first time since 2017, UK firms will have the option to ‘bundle’ research and execution costs.
This article summarises the proposed changes and explores the somewhat potted history of the UK’s research regulatory regime and the practical implications of this proposal.
Why? Two Contrasting Philosophies
There are competing objectives which underpin the respective arguments for the bundling, or unbundling, of investment research with execution services.
“Bundling” permits greater costs efficiencies and value for money, fosters a broader range of available research, allows more flexibility and is more compatible with the U.S. regime.
“Unbundling” addresses concerns around transparency of costs, competition, bias and independence of research.
In recent times, the UK’s position has fluctuated between these.
How Did We Get Here?
- Pre-MiFID II
The bundling of research and execution services was permitted. Investment managers could enter into “soft commission” arrangements whereby a broker agreed to set aside a proportion of commission on transactions for the provision of “substantive research” received by the investment manager. This was subject to certain conditions, for example the research must be capable of adding value to investment or trading decisions by providing new insights to inform the investment manager when making such decisions.
- Post MiFID II, from January 2018
Subject to certain exceptions, an investment manager could only receive research if it was paid for in one of two ways:
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- Direct payments by the investment manager, out of its own resources, e.g. its profit and loss account; or,
- Payments from a separate research payment account (“RPA”), controlled by the investment manager and funded by a specific research charge to the client, and subject to certain conditions regarding the RPA’s operation.
These changes represented a dramatic shift in regulatory philosophy and were one of the most talked about aspects of MiFID II, and the FCA was a key player in pushing for unbundling.
- Post MiFID II Adjustment, from 2021
By 2021, there were two versions of MiFID II following the end of the Brexit transitional period. This adjustment affected the UK version.Recognising the unintended disadvantage to smaller enterprises, which were attracting lower levels of research and correspondingly, of investment, the FCA made changes to the research rules.
The adjustment expanded the list of “minor non-monetary benefits”, to include research on (1) Small and medium-sized enterprises with a market cap of under £200 million – since such enterprises were being overlooked by research providers as well as (2) Fixed Income, Currencies and Commodities (FICC) research – due to the weak connection between execution and the provision of research for these instruments.
The adjustment had the effect of exempting small cap equities and FICC research from the MiFID II unbundling requirements.
- Investment Research Review, July 2023
Post-Brexit saw the introduction of the Edinburgh Reforms – a set of reforms announced by the Chancellor of the Exchequer in December 2022 aimed at driving growth and competitiveness in the financial services sector.The Edinburgh Reforms led to the commissioning of the Independent Research Review (“IRR”). Led by Rachel Kent, a senior lawyer at Hogan Lovells, and forming a significant component of the Edinburgh Reforms, the IRR looked at levels of financial services investment research and its contribution to the competitiveness of UK capital markets. Published on 10 July 2023, the IRR recommended that bundling of research and execution services be reinstated as an option.
The IRR concluded that the MiFID II unbundling requirements adversely impacted the provision of investment research in the UK, which in its turn potentially hampered economic growth. Further, the unbundling requirements would likely reduce UK investment managers’ access to global investment research, setting them at a competitive disadvantage from their international counterparts.
- Contrast with the U.S. Approach / Securities & Exchange Commission (“SEC”) No-Action Letter
In the United States, the use of “soft commissions” – or bundled payments to broker-dealers for combined execution and research services – are commonplace. Commission sharing arrangements are also prevalent. To accommodate and reconcile the MiFID II unbundling requirements with the U.S. regime, and permit the trans-Atlantic provision of research, the SEC issued a No-Action Letter offering relief from registration as an investment adviser to U.S. broker-dealers accepting unbundled payments, for research purposes, from EU and UK investment managers. The SEC’s position under the No-Action Letter lasted for 6 years but finally came to an end in July 2023.
- What about the EU?
The EU has also recognised that the MiFID II unbundling requirements have failed to meet all of its objectives. In a December 2022 proposal, the European Commission advocated reducing the threshold for the existing exemption for companies with a market capitalisation under €1 billion instead of €10 billion.
- The Current Position
While investment managers have shifted their approach to generally procure the research they need, some options tend to be operationally complex or to favour larger investment managers. One major disadvantage of the unbundled approach is its incompatibility with the regimes of other jurisdictions, impeding UK investment managers’ ability to competitively purchase research produced outside the UK.
It is clear that the existing prohibitions on bundling have had significant adverse impacts on the industry. Like many regulations emanating out of Brussels, they tend to favour the larger established research providers – leaving fewer opportunities for smaller providers, with dwindling research budgets and smaller, less experienced research analyst teams. Less competition, poorer quality research are not outcomes we should expect from sophisticated capital markets.
Our experience shows that RPAs, introduced by MiFID II, are predominantly used by smaller firms who lack deep pockets to fund research themselves. The administration of RPAs can be operationally complex and resource intensive, so the smaller investment managers firms face a competitive disadvantage.
New “Third Way”?
Following the IRR’s recommendations, the FCA’s proposal should allow investment managers greater freedom in how to pay for research. It is intended to suit firms of different sizes and business models, and to support the FCA’s competition objective. The proposals are stated to be compatible with rules in certain other major jurisdictions, facilitating cross-border purchase of research.
In summary, the payment options proposed are as follows:
1. Direct payments by the investment manager, out of its own resources;
2. Payments from a separate research payment account (“RPA”);
or the new option:
3. Bundled payment for trade execution and research – within the “guardrail” requirements set out below:
| Proposed “guardrail” requirements for investment managers seeking to use joint payments for third-party research and execution services | ||
|---|---|---|
| 1 | Policy | A firm must have a documented policy on joint payments that:
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| 2 | Agreements | The firm must enter into written agreements with research and execution service providers which establish a methodology for how the research costs will be calculated and identified separately within total charges for such joint payments. |
| 3 | Allocation Structure | The firm must have a research provider payment allocation structure for the allocation of payments between different research providers, including:
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| 4 | Account Administration | The firm is responsible for:
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| 5 | Budget Setting | The firm must set a budget for the purchase of research using joint payments:
If the amount of research charges to clients exceeds the budget set out above, or if the budget is increased, the firm’s policy must set out:
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| 6 | Cost Allocation | The firm must allocate the costs of research purchased using joint payments fairly between clients. |
| 7 | Periodic Review | The firm must, at least annually:
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| 8 | Client Disclosure | The firm must disclose various items to clients, including:
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Any other rule changes?
The FCA also proposes changes to the list of acceptable minor non-monetary benefits (i.e., scenarios that fall outside the scope of the research requirement):
- Extending of the list to include: “Short-term trading commentary and advice linked to trade execution”; and
- Exclusion from the list of research on equities where market capitalisation is <£200 million (the FCA argues, due to “little take up”, and to “avoid additional complexity in the rules”- which a cynical eye might view as “giving with one hand and taking away with the other”).
Notwithstanding the proposed changes above, the list of acceptable non-monetary benefits remains unchanged, including treating corporate access in relation to companies with a market capitalisation <£200 million, as a minor non-monetary benefit.
What happens next?
The deadline for responding to the FCA Consultation Paper is 5 June.
The FCA intends to publish final rules in the second half of 2024 – a tight deadline, from the closing date – but “after carefully considering the feedback … the timetable will be determined by the amount, strength and breadth of the information gathered in the consultation.”
The Consultation Paper proposes changes to COBS2.3A and 2.3B applicable to firms carrying on “MiFID, equivalent third country or optional exemption business”.
The proposed changes do not, at present, apply to COBS 18 Annex 1, which covers Undertakings for Collective Investment in Transferable Securities (“UCITS”) management companies, Alternative Investment Fund Managers (“AIFMs”) and residual Collective Investment Scheme (“CIS”) Operators.
However, the FCA has highlighted its awareness that the proposed changes should also apply to fund managers, including UCITS managers and alternative investment fund managers, under COBS 18. It proposes to set out the rule changes to achieve this alignment in a future consultation in the course of 2024.
What might this mean for the UK investment management sector?
The FCA seeks to remove some unintended consequences of the prevailing regime, whilst avoiding the resurgence of the harms the unbundling rules were designed to prevent. The regulator hopes to have added sufficient flexibility that firms will not be discouraged from taking up the new optionality, whilst ensuring appropriate controls around the use of bundled payments.
MiFID II prompted a seismic shift in the research sector – reduced research budgets at investment managers led to smaller and less experienced analysts at sell-side firms, concentration among the larger research providers, a divergence of EU/UK and U.S. requirements and a detrimental effect on certain firms conducting capital raising activity.
Will these changes allow the UK to return the sector to the pre-2018 position?
Probably no, at least in the short-term. Many commentators in the industry feel that the damage is already done.
In part, this is because we are not returning to the ‘old way’ due to the compliance obligations associated with bundling.
Furthermore, firms – both buy-side and sell-side – might be unwilling to make substantial revisions to their research arrangements given the magnitude of the changes that were required 6 years ago.
FCA evidence shows that larger investment managers tend to pay for their own research, separately from paying for execution. It might be the case that many firms will continue along this path.
For firms using RPAs, which includes many smaller investment managers, arguably the new bundling option is more attractive from an operational perspective. Take-up might be determined by the research providers’ perceived demand for the option. If a small minority of investment managers show interest, there might be less of an incentive to embrace.
From a global perspective, a re-alignment of regulatory rules might benefit UK investment managers, for example in their engagement with U.S. research providers.
For the industry – we hope – a slightly more flexible regime which is fit for purpose across multiple jurisdictions, encourages competition and, per the FCA’s aspirations, promotes “high quality, easily accessible investment research…a vital part of a healthy, dynamic capital market [and] supports the decisions investors make.”
