In a discussion paper setting out the results of its thematic supervisory review conducted between November 2013 and February 2014, the FCA said as a result of the manner in which the market has evolved, there is a lack of price transparency in the market for research. And, it added: “the bundled supply of execution and research services by brokers makes price discovery difficult.”
After considering a range of views garnered through roundtable discussions with over 130 firms and trade bodies, the regulator is of the opinion that a total unbundling of research from dealing commissions would be the most effective way to “address the continued impact of the conflicts of interest created for investment managers by the use of a transaction cost to fund external research.”
This view is consistent with that posited by the European Securities and Markets Authority (ESMA) in a consultation paper on its advice on proposals for MiFID II Level 2 measures that will support MiFID II Level 1, which was finalised in January 2014.
Under MiFID II Level 1 significant restrictions have been placed on investment managers in terms of the type of goods and services that can be received from third parties linked to the services provided to clients, including that they are only allowed to receive so-called ‘minor non-monetary benefits’.
According to the FCA, ESMA’s advice includes specific proposals on what will be permitted as ‘minor non-monetary benefits’ that has been very narrowly construed, following the intention of the Level 1 in otherwise banning all inducements for portfolio managers.”
The effect of this narrow construction is that only widely-disseminated, generic research will qualify as an acceptable minor non-monetary benefit.
The FCA adds, ESMA states that: "any research that involves a third party allocating valuable resources to a specific portfolio manager would not constitute a minor non-monetary benefit and could be judged to impair compliance with the portfolio manager’s duty to act in their client’s best interest."
According to the regulatory body, while currently the changes under MiFID II requirements on portfolio managers would not apply to UCITS and AIFMD investment management activity without wider changes, “the FCA would strongly support a uniform application of any changes to the inducements rules –that in turn affect use of dealing commission arrangements – across MiFID, UCITS and AIFMD investment management activities.
FCA chief executive Martin Wheatley said: “There is strong evidence to suggest the current model of using dealing commission to pay for research reduces transparency and creates a link between research spend and trading volume, without a clear assessment of the value this offers to investors. I want to see a level playing field across Europe to ensure the market delivers the best outcome for investors”.
The review
Of the 17 investment managers considered within the thematic review, the FCA reported that, while many had made improvements since November 2012, only two firms were operating at the expected level.
At 11 investment management firms, The FCA said: “the amount paid for research with dealing commission remained linked to the volume of trades carried out as they did not have research budgets or caps on research spend.”
And, one large firm was using dealing commission to pay for market data services in full with no apparent mixed-use assessment.
“This was despite us setting out our views on the need for firms to assess the eligibility of payments for these services in reports in both 2008 and 2012. Following our engagement, the firm has ceased making payments for these services using dealing commission,” it said.
On the broking side, the FCA said, firms did not explicitly price their research as a distinct service, leading to price opacity in the market. But, while brokers had not given adequate consideration to their potential conflicts of interest, this was somewhat mitigated by corporates being aware of these potential conflicts.
