A granular understanding of the several types of costs and charges is important for all market participants. These can have a substantial effect on investors’ returns (see graph below) and, if disclosed effectively, should facilitate market efficiency. With this in mind, regulators have gone to considerable lengths to implement all the necessary requirements related to the disclosure of all costs and charges associated with the provision of investment services – thereby increasing transparency in the market.
However, as with most of the regulatory landscape, the regulators’ intent has been muddled by the complexity of the financial markets. Although the framework regarding the disclosure of all ex-ante and ex-post costs and charges seems to be well defined by the European Securities and Markets Authority (ESMA) in the Markets in Financial Instruments Directive (MIFID II) and the Packaged Retail and Insurance-based Investment Products (PRIIPs) regulation, several questions remain unanswered and leave the directive open to potential misinterpretation.
Areas of immediate concern tend to look towards the methodology required to aggregate costs’ the scope and definition of limited disclosure, the standardisation versus non-standardisation of disclosure; and, most relevant to this analysis, the definition of implicit costs, particularly those related to transaction costs.
This last point is vital. With the implementation deadline of MiFID II around the corner, firms are expected to have a granular understanding of the regulator’s prescribed measure on the definitions of “all costs and charges”. This definition is still the subject of debate. The following analysis will attempt to clarify this doubt and highlight the impact it has had on firms’ ability to prepare for the launch of MiFID II.
Transaction costs: the how, who and why?
One of the most controversial areas which, as yet, remains unresolved is the common approach to the definition of certain transaction costs, particularly ‘implicit costs’. These ‘implicit’ transaction costs, described by ESMA as all costs incurred in order to acquire and dispose of investments, present practical difficulties for those attempting to quantify charges for the purposes of client disclosure.
Along with commissions or other fees, transaction costs represent a significant outlay to investors, especially in markets, such as the fixed income, foreign exchange and derivatives markets, where transaction costs are embedded in the bid-ask spread of the financial instrument, making them hard to quantify. The issue deepens when other categories of ‘implicit’ costs considered by the practitioners of Transaction Cost Analysis (TCA) are added into the equation. Typically, these additional variables arise variously from the response of the market to a trade or the timing of a trade. Specifically, they consider:
- Market impact – executing a large order in one go can move the market, meaning that the price obtained is different from what was expected
- Delay – the price differential from order initiation to the point where their order is placed on the market. Fund performance can be affected if the market moves during this period and, therefore, could elicit a cost
- Opportunity cost – if a trade of a certain size is partially executed, it runs the risk of missing out on the opportunity to participate in favourable movements in the market. This risk is typically considered to be a loss in value and, consequently, a potential cost.
Blackrock, in their ‘Guide to Transaction Costs’, sum up the nature of these costs succinctly, stating how “we don’t know objectively what they are, so we typically estimate them using proprietary models”. In this regard, much of the confusion stems from the lack of a common harmonised model to calculate these costs across firms. For instance, MiFID II identifies how the market movement between the initiation of a transaction and its completion (the implicit costs identified above) should not be included in transaction costs, whilst the PRIMP KID’s main transaction cost methodology implies the inclusion of market movements.
Semantics – whatever you say it is … it isn’t
The inherently practical difficulty in quantifying these charges has been addressed by several regulatory bodies in an attempt to clarify and provide guidance for market participants. ESMA’s latest ‘Q&A on MiFID II and MiFIR investor protection and intermediaries topics’ suggests that firms use the PRIIPs RTS calculation methodology to ensure that both explicit and implicit transaction costs are captured on both an ex-ante and ex-post basis and for the purposes of both MiFID II and PRIIPs obligations. This clarification by ESMA has been welcomed by several market participants, such as BNP Paribas, who contend that increased flexibility on the appropriate methods should help reduce the compliance burden and streamline document protection.
The FCA has also addressed the issue. In its final report, the UK regulator decided that it will supplement forthcoming MiFID II and PRIIPs requirements, rather that immediately introduce its own rules. In particular, the FCA is concerned that transaction costs are not disclosed to investors before they make their investment decision and that common practice delineates that charges are estimated in advance, meaning that investors bear the risk of disclosed charges being different from the estimates. In the FCA’s view, this lack of cost transparency is likely to contribute to limited price competition between actively managed funds and asset managers’ ability to control complex costs. Their proposed solution is the introduction of an ‘all-in’ fee approach to quoting charges which, following the application of MiFID II, will include an estimate of transaction costs (technical detail on this methodology can be found here.) Their proposals are currently being reviewed by the markets, with further consultation papers on this topic expected to be published by the end of this year.
JWG are here to help
The importance of a standardised approach to the measurement of transaction costs should not be understated, especially because of its relation to market transparency and its role in promoting fairness and efficiency in the markets. In our view, all market participants should continue to collaborate on these issues, ensuring that (i) they are well prepared to meet MiFID II cost and charges obligations come 3 January 2018 and, more importantly, (ii) they act in the best interest of investors and market competition.
Our next Client Management Services Special Interest Group (CMS), due to be held on 13 September, will consult on the issues raised in this article with several market participants to formulate a standard approach to the modelling of transaction costs for client disclosure purposes.
We are always keen to hear from market participants with expertise in client management services. Please contact CMS@jwg-it.eu if you would like to get involved. You can also keep up to date with client management related news on our LinkedIn Group or follow us on Twitter and subscribe to our newsletter alerts.