The MiFID 2 Research Unbundling Anomaly

With January 2018 fast approaching, the assessment of investment research requirements under the Markets in Financial Instruments Directive (MiFID 2) is generating debate around the most suitable global model. 

Why are the MiFID 2 research unbundling rules attracting so much global attention? 

The MiFID 2 research unbundling rules require asset managers to pay for research and execution services separately, eliminating the receipt of research through bundled client commissions. Under MiFID 2, any receipt of free research is considered an inducement and is a violation of the new rules. Asset managers will be required to pay for research from their profit and loss accounts directly, or direct advisors to pay for research only through prescribed methods, such as Research Payment Accounts (RPAs), where research costs are passed through to the funds as a direct expense.

The new EU rules have received attention globally because they directly conflict with US securities laws, which are based almost exclusively on bundled commissions. Since most securities and asset management firms trade in both US and EU markets, any shift in the EU trading rules has global consequences.

How do the new rules conflict with the US rules?

Under the Securities Exchange Act, US broker-dealers may not receive direct payments for their research without invoking a special compensation clause. To lawfully receive direct research payments, brokers need to register as investment advisors with the Securities and Exchange Commission (SEC) and adhere to significantly higher regulatory obligations. The new MiFID 2 research payment methodology also makes it difficult for US advisors to remain eligible for safe harbor provisions set out within the Securities Exchange Act, which provide certain protections for advisors and funds against claims of excessive charges for commissions.

The new MiFID requirements will also significantly impact soft commissions. Currently, soft commission programs operate globally based on aggregated research payments across multiple accounts and the costs are divided equitably among funds. Once these costs are documented, allocated, and disclosed, soft commission programs operate in a relatively uniform manner in both the EU and US.

Today, portfolio managers, regardless of where they are located, generally draw from a single pool of research which is shared freely. MiFID 2 will require that research be ring fenced and only used for investors who have paid for it. Firms cannot use the research internally for the benefit of other products or clients. Ring fencing of research ultimately leads to ring fencing of trading activities as they are inextricably linked together under MiFID 2.

Aggregating trading and research has benefits to clients since it’s cost effective and generally results in better performance outcomes. On a practical basis, having a single operating model is preferable for all parties than having to run and oversee different processes on the same underlying securities.

What are the next steps for the SEC?

Due to the global nature of asset management, a divergent rule set between two of the largest global capital markets for research payments is not optimal.

The SEC is already deep in discussion with EU regulators, asset managers, and industry associations hoping to find a workable solution for all. Industry organizations have made formal submissions to the SEC requesting they address the trading and research ring fencing issues well in advance of the January deadline.

The SEC has two options:

  1. Decline to Comment

The SEC could state that MiFID 2 is an EU regulation beyond their span of control. However, given the importance of this issue, it is highly unlikely that they will simply decline to comment.

If there is no clarification on the current disconnect, US advisors will be left in MiFID 2 planning limbo.  They will then need to decide whether to absorb cost of research for all clients, just MiFID 2 clients, or move to the RPA model.

  1. Offer Exemptive Relief

The SEC can formally provide advisors partial or temporary relief from particular rules, on an individual or collective basis. These reliefs can take the form of no action letters, exemptive relief, or interpretative guidance on how a particular rule should be complied with.

What is the most likely outcome?

At this point, the industry would welcome any form of relief from the SEC for the research unbundling requirement in advance of the January 2018 deadline. It is very likely the SEC will allow US advisors to continue to aggregate orders and apply the prescribed methods of research payments set out in the MiFID 2 rules. A broker dealer exemption for receipt of direct payments for MiFID 2 activity without registered advisor status will be needed as well.

The global asset management industry is waiting with bated breath to see how the SEC will handle this. It is not in the interest of either EU or US regulators to leave this issue unresolved until January 2018. In the meantime, Asset managers should not wait for relief that may not come and should plan for the worst-case scenario where they have to run two separate trading books, one for their MiFID trading activities and another for everything else.