The clock is ticking and the EU market has less than half a year left to implement the regulatory changes required from it. The revised Markets in Financial Instruments Directive (MiFID II) sets new legislation effective 3 January 2018, containing a range of complex provisions intended to enhance transparency and investor protection within the financial industry, along with other objectives.
A survey conducted by JWG found that 90% of buy-side firms believe that they are at “high or medium risk” of non-compliance by the January 2018 deadline, despite this date having already been pushed back a year. Considering the confusion and uncertainty surrounding the rapidly approaching deadline, it is imperative these regulatory reforms are understood by the European firms involved.
While the rules will widely impact the financial system, attention should be placed on the buy-side, as MiFID II requires sweeping changes to best execution, unbundling of research payments and trade reporting. All in all, MiFID II will require a higher level of compliance from the buy-side than it is used to, especially concerning investment research and the topic of inducement.
Article 24 (8) of MiFID II prohibits investment managers accepting “fees, commissions or any monetary or non-monetary benefits paid or provided by any third party”. In principle, this reform will still allow investment firms to receive research from third parties, but greatly limits its scope in order for the action to not contravene inducement rules.
As mentioned in our previous article, three options are available in order for a research service to be deemed permissible. One option is that buy-side firms can pay for research – provided they pay directly from their own profit and loss account (P&L). Additionally, a firm can use Research Payment Accounts (RPAs) by either direct or transaction based payments. Furthermore, buy-side firms that receive investment research must set a budget for research as well as justifying the price of research and the quality of content.
While some contingencies have recently been made clear, such as determination of research pricing and the duration of free trial periods, other areas within the guidance still remain ambiguous and require explicit clarification, such as VAT exemptions and client money which is further discussed in this article.
There has been a great deal of uncertainty surrounding research pricing and application. However, current updates to our MIG guidance, which are created for each of our MIG meetings, resolve some questions concerning MiFID II. Initially, it was not explicitly stated whether the buy-side or the sell-side would determine the price of research. The MIG guidance update provides some clarity on this potential issue, stating that there will be no third party that will determine the price of research and that firms should internally agree their own research pricing methodology. While, naturally, the buy-side and sell-side will have to push back and forth for a bit, it was also suggested that “the price will be an output following a process of commercial negotiations”, ensuing that, while there might be a period of negotiations, eventually the market will clear and the correct market price will be determined.
Free trial periods
Whether or not free trial periods for research services constitute a breach of the restriction on unpaid research has been a significant topic of discussion within the MiFID II directive. The Financial Conduct Authority’s final policy paper on the implementation of MiFID II has allowed research firms to offer free trial periods for up to three months, constituting “an acceptable minor non-monetary benefit” for firms. Details concerning the duration of free trial periods have been an ambiguous topic within the MiFID guidance but, now, short trial periods for research services are permissible on condition that the firm does not pay the research provider during this period and does not return to a provider for a new trial within a year. In theory, trial periods will force investment firms to be more selective when deciding which research firm to work with as well as pressuring providers to present higher quality of research.
With the required unbundling of the costs associated with research under MiFID II come various forms of tax implications, especially concerning Value Added Tax (VAT). Under the current regime, bundled research is VAT exempt but, with MiFID II and its subsequent laws pertaining to unbundled research prices, many questions arise concerning firms that may now have to pay VAT on research.
The ambiguity surrounding how VAT exemptions will be treated under MiFID II is still unresolved. While the MIG meeting’s agreed upon position states that the buy-side will have to “self-assess if VAT is due, i.e., if the client is responsible for VAT”, further clarification is needed on details of the process. It is suggested that firms could consider starting with exempt VAT prices, allowing themselves the ability to add VAT if required. Overall, research unbundling will significantly complicate research pricing, and concern is understandable considering that there is less than 5 months left until the MiFID II compliance deadline.
Article 13 of the MiFID II Delegated Directive states that, where an investment firm chooses to use a RPA, it must be funded by a research charge to the client. Once this charge is deducted from the client, the funds belong to the firm. This research fund should be managed in a RPA controlled by the investment firm but, nonetheless, should still be used explicitly for purchasing external research to benefit the client.
This issue is complicated and there is still a great deal of uncertainty on what would be deemed as client money, ‘firm money’ or research provider’s money. Many suggest that the funds within the RPA should be treated as client money but, if this is the case, this money would be subject to additional client money rules, which are subject to greater scrutiny by regulators. With limited time left before the compliance deadline, the buy-side requires a clear understanding of who the RPA account funds belong to in order to fulfil other requirements attached to it.
As we head towards the 2018 deadline, it is imperative that buy-side firms understand all aspects of the changes required from them.
There is no singular path to compliance, especially for buy-side firms that have viable options in terms of implementing these guidelines. However, considering the many ambiguities that exist within the MiFID II requirements, and the short stretch before the January deadline, the buy-side should be especially alert for new clarifications being published.
Other buy-side topics are discussed in our MIG meetings. Upcoming MIG meetings are:
- 3 August 2017 – MIG: algo/HFT call 1
- 16 August 2017 – MIG: product governance call 4
- 31 August 2017 – MIG 95: best execution.
If you wish to find out more about MIG, please contact email@example.com. You can also keep up to date with MiFID II related news on our LinkedIn Group or follow us on Twitter and subscribe to our newsletter alerts.