RegTech Intelligence

The long-awaited divorce: saying goodbye to bundled commissions

JWG analysis.

The removal of a number of financial practices has altered the regulatory environment in recent decades.  With new landmark legislations coming in to play soon, regulators across Europe look set to bring down the curtain on another.

Under the existing practice of bundled commissions, asset managers charge clients to manage their funds but also have free reign to use investor resources for a varied range of broker services to complete the work.  However, this currently takes place without any rigorous guidelines governing what asset managers can purchase and how much they can spend.

Lord Myners’ 2001 inquiry into fund management shed light onto this regime and initiated the first set of ‘unbundling’ debates.  Yet, over a decade later, partial reforms have not amounted to much change.

Regulators are now looking to sever the link between researching and trading once and for all, stressing the need for greater transparency on the price of research.  This hard line approach will enforce new rules that are set to trigger one of the industry’s biggest upheavals since the 1986 ‘Big Bang’ reforms.

What the regulators want

‘Unbundling’ forms a key part of the regulatory reforms that are looking to change the financial landscape of Europe in 2017.  Currently, the MiFID II rules are proposing changes to the way in which research services are paid for.  The European Securities and Markets Authority (ESMA) has also suggested that the regulations may go further by altering the coverage and availability of these services.

Although discussions on the final wording of MiFID II are still ongoing, the position of the Financial Conduct Authority (FCA) has become much stronger in recent years and is unlikely to change.  The slow progress made by asset managers and brokers so far has forced the FCA’s hand to use far more draconian measures.  In the same vein as MiFID II, the FCA regulations ask for asset managers to separate research and execution costs and put distinct research budgets in place.  In addition, these research costs will have to be treated as a charge to the asset manager, rather than coming out of client funds.

The FCA’s review of the use of dealing commission regime states that the UK will not be implementing these regulations unilaterally.  As well as ensuring that further reform within this industry is compatible with MiFID II, the FCA confirmed that they are discussing changes within the industry with other international regulators through the International Organisation of Securities Commission (IOSCO).

The future ahead

Undoubtedly, these new regulations will have a significant impact on both the industry and its participants.  However, reactions from industry experts could not be more different, with some predicting dire consequences and others forecasting prosperous days ahead.

One apocalyptic scenario encompasses the demise of brokers.  Currently, asset managers are being forced to cut their management fees in order to compete more effectively.  As a result of this, they have reduced the commission they are willing to pay brokers.  If asset managers are required to pay for research from the company’s profit and loss account, they are likely to be more particular about the research they take.  This has heightened the resistance towards full ‘unbundling’ from brokers, who fear that asset managers will not be willing to pay for their research, leading to dwindling revenues.  In addition, there are fears that fund managers will also suffer, with the smaller ones being significantly disadvantaged due to a lack of capital to pay for independent research bills.

At the opposite end of the spectrum, industry specialists are seeing a more positive outlook for brokers.  Many agree that, although the short term is likely to be painful as, unlike investment banks, these businesses do not have alternative revenue streams, in the long-run opportunities could be substantial.  In fact, independent research providers are more likely to prosper if they offer more tailored, interesting and value-added research which cannot be replicated elsewhere.

The most worrying suggested development is that, without reliable research, liquidity will dry up.  Anxious experts have stressed that ‘unbundling’ will mean the disappearance of broker research within all but the most heavily traded stocks as it will become too laborious and expensive to cover.  This declining coverage could lead to a lack of understanding and, therefore, value discovery will be more challenging.  If a stock’s liquidity reduces, it will be harder and more expensive to execute trades.

Although it may be too early to accurately predict what the impact of unbundling will be, it is obvious that the direction of regulations is becoming more consistent and clearer than before.  With brokers and asset managers both facing significant structural and strategic challenges ahead, there is no point in waiting for the MiFID II texts before ensuring appropriate controls are in place to deal with these new rules.

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