By Dominic Hobson, COOConnect.
If you are a hedge fund manager, it is always tempting to believe that you are too small to be of interest to regulators.
The new rules on the use of equity commissions, published last month by the Financial Conduct Authority (FCA), the United Kingdom regulator, probably fall into this category.
Yet the rules, which came into effect on 2 June, apply to every fund manager, and not just the top 200 managers that the FCA (or at least its predecessor body, the Financial Services Authority) enjoined to commit to them in its original “Dear CEO” letter of November 2012 on conflicts of interest in fund management.
The new rules have three principal effects, each of which has implications for how equity commissions are used to buy investment research, and therefore wider ramifications for the relationships between fund managers and their prime and executing brokers.
First, managers are now obliged to prove that they have controls in place to govern how they purchase investment research. A commonplace rule is to cap the research budget with each broker, and switch to an execution-only relationship once it is breached.
Secondly, managers must prove to the satisfaction of the regulator that they are using equity commissions to buy “substantive” research only, which means it must offer “meaningful conclusions.”
Thirdly – and in some ways, most importantly – corporate access does not fall into the category of research that is either “substantive” or which reaches “meaningful conclusions.”
It is easy to see why the FCA reached this conclusion. Anyone who has attended a corporate access encounter will know that nuance is far more important than any concrete leads on corporate performance.
Yet the re-characterisation of corporate access as something other than investment research means that managers must now meet the costs of such occasions out of their management fees.
There is a view that the same ought to be true of all forms of investment research. Since the FCA has made clear that PS 14/7 is not its last word on the subject, it would be imprudent to rule out the possibility that regulators will one day insist on exactly that.
Of course, this would be difficult to achieve in one country. If managers based in the United Kingdom were forced to inflate their management fees to include the costs of research, they would find it difficult to compete.
Not impossible, of course. There probably is a constituency of institutional investors out there that would be impressed by such transparency on costs, but it is a bold investment manager who chooses to pioneer that theory in practice.
Transparency may be a cant word, but it is having real consequences. Nowhere is this more apparent than in the consultation paper published by the European Securities and Markets Authority (ESMA) following the agreement of the European Parliament and Council on the text of the second version of the Markets in Financial Instruments Directive (MiFID II).
The document is well over 500 pages in length, but even a peremptory perusal of the contents page finds an entire 150 page section devoted to pre-and post-trade transparency for equities, bonds and derivatives. Another 86 pages are devoted to the reporting of market data.
Transparency, not openness, is what MiFID II is all about. And that includes transparency into costs. This is not widely appreciated, because most of the transparency sections are devoted to price disclosure in trading markets.
So it is worth looking at section 2, Article 24, paragraph 4(c) of the text of MiFID II itself, since it obliges fund managers to disclose all costs – management and performance fees and spreads as well as commissions – to clients:
… the information on all costs and associated charges must include information relating to both investment and ancillary services, including the cost of advice, where relevant, the cost of the financial instrument recommended or marketed to the client and how the client may pay for it, also encompassing any third-party payments. The information about all costs and charges, including costs and charges in connection with the investment service and the financial instrument, which are not caused by the occurrence of underlying market risk, shall be aggregated to allow the client to understand the overall cost as well as the cumulative effect on return of the investment, and where the client so requests, an itemised breakdown shall be provided. Where applicable, such information shall be provided to the client on a regular basis, at least annually, during the life of the investment.
The text of MiFID II (see paragraphs – or “recitals” as they are technically known – 74 and 75 of the preamble) also muses about the possibility of restricting further restricting the ability of fund managers to receive inducements from third parties. Investment research obviously falls into this category.
The ESMA consultation paper on MiFID II addresses this issue directly (2.15, page 118-121, paragraphs 12 to 16 in particular) in what might or might not be a more disturbing way.  Under MiFID I, receiving research paid for by a third party broker was legitimate provided it was disclosed, and did not impair the ability of the manager to act in the best interests of the client. On the face of it, the ESMA paper on MiFID II does not indicate any serious departure from this position.
In effect, the ESMA consultation paper says that research which is widely distributed will not be treated as an illegitimate inducement likely to cause a fund manager to do something he or she would not otherwise do. That is because it is of low value, and low value research cannot count as an inducement, whereas research of high value probably does.
But how will that translate into practical, day-to-day reality? One way to think about it, as the ESMA text indicates, is how many people see a piece of research. If everybody in the market sees it simultaneously, it is almost certainly worthless. Corporate access, on the other hand, will almost certainly count as research of the highest value, if only because not everybody sees it at the same time.
The unanswered question this poses is whether the MiFID II rules inadvertently ban the use of equity commissions to purchase research, since restricting research distribution to those who have the means to pay for it will – by the MiFID definition – be of higher value.
It will therefore have to be purchased out of the management fee. If it does, that presages a revolution in the equity research business that will make the new FCA rules that came into effect on 2 June look positively innocuous.