With only two months left until implementation, MiFID II research rules have been one of the most discussed issues within the industry. Under the new rules, investment firms will no longer be able to accept research as a non-monetary benefit, unless a firm can prove that the research passes the quality enhancement test and that the research is classified as a non-monetary benefit. This has caused much debate about how much firms will charge for research within the industry; some firms have decided to provide research as part of their services whilst others have announced they will swallow up the costs. This article will explore the impact of MiFID II research within the industry and discuss how buy-side and sell-side firms have decided to comply with the new rules prior to implementation.
Obligations of sell-side and buy-side
Under the new rules, buy-side and sell-side firms have several obligations to follow which they did not have prior to MiFID II new research rules.
Sell -side firms providing investment research are required to:
- Provide clients with unbundled costs of services, separating the price of execution, research and advisory services
- Ensure their firm does not induce clients by providing research below the cost
- Categorise the content they provide to clients against the definition of research under MiFID II.
Buy-side firms receiving investment research are required to:
- Make explicit payments for research, demonstrate that their research contributions allow investors to make better investment decisions and, therefore, show that it is not an inducement to trade
- Provide better reporting to facilitate payments being made for research and demonstrate the value that research is providing to their services
- Set a budget for research and ensure payments for content are reasonable and justifiable, taking into consideration the quality of the content.
The purpose of these obligations is to mitigate conflicts of interest and ensure that research is not being offered as an inducement.
Why is it causing so much contention?
These changes have caused much contention because, under the existing rules, when a buy-side firm increases its trading volumes, its overall fees will increase despite it receiving the same amount of research. These costs will then be passed on to its clients. Under the new rules, this will no longer be possible. Buy-side firms must not link the amount paid for research to the volume or value of transactions. Instead, they must agree a budget for research to be paid for upfront and this must correlate to the quality and value that the research would add to the end investor. This gives buy-side firms two choices. They can either pay for research directly from their own account, or pay using client commissions and a research payment account which is supported by a Commission Sharing Agreement. This codifies how costs are split into execution costs and research costs, and how commissions are to be shared amongst research providers.
To support this, sell-side firms are required to separate the costs of research from the cost of execution. In this way, buy-side firms will be able to make explicit payments for research they receive. The impact of the new rules is that, for the first-time, asset managers are taking a hard look at the quality of research they receive to determine what is worth paying for which, as a result, means that firms will have to closely assess how much their research is worth – difficult to do in practice as the value of research is inevitably subjective and depends vastly on many factors.
According to Bloomberg, “smaller hedge funds are working with larger hedge funds to share the costs of complying with MiFID II research rules, they are increasingly collaborating on platforms to share the costs of research.” The challenge for smaller firms is that they cannot absorb the costs of research that the legislation requires, as they do not have the same budgetary capacity as larger firms. As such, when smaller firms collaborate on these platforms, it helps to reduce the costs of accessing research. The platforms would also provide smaller buy-side firms with extra bargaining powers to negotiate the price of research with larger sell-side firms which they would not normally have on their own.
Other firms have decided to continue to pass the costs of providing research on to their clients, albeit in a more transparent way than in the past.
Nevertheless, smaller buy-side firms have some positive advantages over larger sell-side firms in the context of these requirements, in that some investors prefer more of a niche coverage as opposed to paying for broad chunks of research from the large firms. In addition, smaller buy-side firms have been charging for research for years, which gives them an edge over larger institutions who are still trying to ascertain how much their research is worth. Another positive advantage is that, because small research providers are independent, they can reassure fund managers that they do not have to grapple with any conflicts of interest. This is important, as one of the objectives of the MiFID II research rules is to stop investment firms from receiving research as a possible inducement to trade.
Overall, the new MiFID II research rules will have a huge impact on the flow of investment research through the industry. However, it is possible that the new rules are only going to reinforce the advantages that larger and wealthier asset managers have always had over smaller players. Much remains uncertain and we will only know the full impact of these rule changes on how research is produced and sold within the industry between sell-side and buy-side firms after 3 January 2018.
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