Banking and Regulation (and undoubtedly these days it merits the capital ‘R’) increasingly seems to go together like bacon and eggs, Marks & Spencer, and perhaps even Chelsea and boring, with apologies to Mr Mourinho.
Of course, ever since we all learnt the real implications of ‘sub-prime’, the halcyon era of toothless, easy-going regulators, which was maybe more felt to be the case in the UK than in some other jurisdictions, has gone, and is not coming back any time soon. With Libor, Fx, mis-selling and various other ‘scandals’, the importance of effective, transparent and strong regulation is undeniable, and quite simply a good thing. Having discovered their bite, regulators are far from finished. There are considerable tailwinds in their favour, with the general political climate of all bankers being knaves or fools (and supposed more likely the former); the seemingly endless illustrations of further improprieties; and the growth of a compliance-led, risk-averse culture.
Such momentum may lead, however, to a bonfire of the virtues, as well as of the vices, of the investment & banking communities. One clear case in point is the onset of MiFiD2, due for enactment across the European Community in January 2017. The scope of MiFiD2 is daunting, and covers a great deal beyond the scope of this article. But one aspect of MiFiD2 that potentially fits this bill is the question of payments for research - not only for equity, but equally so for fixed income and indeed all other asset classes. The cash equities market has been the main area of attention, partly because payment and value attribution for research services already exists here, however imperfect, and also due to the perennial perspective of the equity market being more legible and high profile than its giant bonds cousin.
For well over a decade, the practice of paying for equity research consumed by asset managers, bundled up in trading commissions, has been under review from regulators, led by the FSA, and now the FCA in London. Under MiFiD2, that long journey now looks likely to reach a conclusion. The current intended rules (although it is possible they may yet change to some degree) set out that asset managers must fully separate payments for research & advisory services from trading & execution commission payments. There has to be a separate, defined research budget, and a process in place to evaluate services received, for which payments would then be made from that budget. It can be underspent, and the balance rolled over, to the next period, or indeed the next year. However, any requirement to increase the budget within the year (maybe due to new mandates or a shift in investment strategies) will need to be passed by ultimate clients. The guidelines recommend the establishment of a Research Payment Account (RPA) to formalise and enshrine this process. Any payments made cannot be linked in any way to execution payments.
In coming to terms with all this, both asset managers, as the consumers, and the brokerage firms and research houses, as the suppliers, are wrestling with both short term concerns, and the more fundamental issues of potential unintended consequences of the change in practice. The immediate factors are about the administrative practicalities in RPAs. How are they funded – still in a quasi-commission way; via a stipend on client funds, or in true hard dollar from the asset managers P&L, with costs reclaimed via the annual management charge? Will the existing, and growing practice of Commission Sharing Agreements (CSAs), to handle such payments, now be debarred, or at the least unsupported by the regulator. Does the budget actually require the OK of every ultimate client, and if so, how could that work in practice? Is there a requirement on suppliers to give a price for all of their services, and how will that work, in a world where the same analysis, report or meeting can be worth much more to person A than it is to person B?
There already is a sense of unintended outcomes here, in that some asset management firms are considering operating their research payments from their own P&L. This is to avoid the administrative complexities, with the view that for the ultimate client, the end cost is neutral (shifting a payment via commissions to one via the management charge). But such an approach also then means that the buyside can pay this money for services they define are of value. So items such as corporate access, now considered not allowable for payments under FCA rules, would then be capable of being charged for, and paid, possibly in ways which lets an asset manager ‘step outside’ some of the regulatory environment.
However, it is the more fundamental, ongoing unintended consequences which could cause greater problems. Smaller asset managers, smaller brokers or research houses, and smaller companies all face potentially tricky times. For those on the buyside, the likely reduction in the amount and availability of research will hit them harder. With fewer in-house resources, and less ability to spend, they may find it harder to access research and advisory services, thus damaging their opportunity to identify value and generate returns. Of course, larger asset managers have long felt they were in effect ‘subsidising’ the cost of research across the market, and it can be argued a change away from that is leading to a more realistic market. For brokers, it is a similar picture, where the ability to receive reasonable returns from research may become more restricted, and essentially make the provision of research uneconomic to many of their clients. And for companies, reduced research will mean even less coverage of their stock; less liquidity in the stock, and a tougher task to getting buy-in and interest in their corporate story.
Over time, doubtless the market will reach an equilibrium. If research is of value, and if there is an appetite for it – on large stocks or small – then a market will grow up to match that appetite, and to realise that value. The question is – how long it may take to get to a point of balance, and what damage to the market – and hence to the return to investors – may be caused en route.
By Steve Kelly, Head of Europe, WeConvene Extel