Complying with the Markets in Financial Instruments Directive
The MiFID II investment research challenge
There is an extraordinary buzz in the US investment management (IM) community about complying with the European Union’s sweeping new Markets in Financial Instruments Directive, known as MiFID II, which goes into effect January 3, 2018.
November 8, 2017
A blog post by Doug Dannemiller, Investment Management research leader, Deloitte Services LP.
Much of this buzz concerns the new requirements around research payment transparency, which the Securities and Exchange Commission (SEC) clarified recently through the issuance of three no-action letters.
In short, MiFID II is a far-reaching directive covering multiple aspects, including trading venues to the distribution of financial products. And Deloitte has published a number of viewpoints on the implications of MiFID II for participants in European markets.1
But MiFID II’s impact goes beyond the European investment industry. US investment managers that serve US and European accounts face complications as they look to comply with MiFID II regulations covering how research is purchased, parity in commission levels, and trade allocation. MiFID II calls for the unbundling of research payments from commissions. The object is to improve the transparency of fees customers are paying for their services.
One complication comes from the firms producing the research in the United States, often sell-side brokerage firms. These firms currently offer their research in exchange for order flow, and they do this, at least partly, because charging for investment research explicitly places the firm in an additional regulatory framework. Firms that sell research in this manner are considered investment advisers by US regulators. Many sell-side firms have structured their businesses to avoid this designation and its associated regulatory requirements.
Under MiFID II, US investment managers are supposed to buy their research from some providers that, until the SEC’s letters of Oct. 28, 2017, did not want the hassle of selling it, instead of providing research under a commission-sharing agreement.2 This letter provides relief for sell-side firms selling research for the next 30 months. It is far from a permanent solution. This is a clear example of something that may make sense for European markets but causes headaches for US IM firms.
One potential solution being discussed is for all research to be paid for transparently, either as part of the trading commissions and disclosed, or by IM firms, separate from any trading activity. The problem with the transparent approach is that it runs counter to the long-established business model at US sell-side firms; these firms now have temporary relief. Although Bank of America Merrill Lynch has moved to form a US investment adviser through which it will sell research, it is the first large sell-side firm to do so.3 This approach does not have to utilize the temporary relief, and, as such, is a long-term solution.
US investment managers that serve US and European accounts face complications as they look to comply with MiFID II regulations covering how research is purchased, parity in commission levels, and trade allocation.
MiFID II: Consequences and compliance
The unintended consequence of this disruption is that sell-side firms may either spin off research arms, move the research arms to a favorable regulatory jurisdiction, or stop providing research. Few sell-side firms want to increase their scope of regulation, so their urgency for action has been mitigated. The danger of this longer-term scenario is that with explicit costs (carried by either the IM firms or by the customers) there may be a cutback in the amount of research consumed.
IM firms will be left with to decide (1) do I buy that research or (2) is it safe to proceed without it? This may seem like a reasonable choice, however, firms making that choice are at the disadvantage of never really knowing if there is a golden nugget in the research that would influence their decision. How many firms will consume the same amount of research when the charges are explicit?
Another solution that comes to mind to comply with MiFID II is to manage clients by jurisdiction, processing each according to their regulatory requirements. While accounts and clients can be assigned to specific jurisdictions, this approach does not lend itself to the centralized tasks within IM for cross-border activity, such as trading and the investment decision process, both of which are tightly related to the research on a given issuer. As a result of these complications, some IM firms will treat both US and European clients as though they are subject to MiFID II.4
Consider this example: Assume a portfolio manager (PM) at a US IM firm likes the story for a particular fixed-income security. The PM serves multiple accounts, each with the same mandate. However, some of the accounts are under European regulatory authority, and some are US-based. The US sell-side broker offering the bond issue, in this hypothetical case, provides research to the buy-side firm. The IM firm has exceeded the required order flow in exchange for the research. Are the European accounts supposed to pay an additional fee for research that was essentially already paid? If so, how much? It seems that operating under both regulatory models based on client jurisdiction may be too complicated to work.
The research component of MiFID II is going to drive strategic decisions for IM firms regarding client treatment and research purchases. Have you made all the decisions about MiFID II? How do you think this conflict will be managed in the long-term? Please share your thoughts on the impact of this new directive. Join the conversation on Twitter: @DeloitteFinSvcs.
1 Nikki Lovejoy and David Strachan, “Navigating MiFID II Strategic decisions for investment managers”, Deloitte UK, March 2015.
2 William Yonge, “Effect of the MIFID II research regime on US Investment Managers”, Morgan Lewis, 18 April 2017.
3 Peter Smith and Robin Wigglesworth, “BofA breaks ranks to take investment adviser status ahead of Mifid,” Financial Times, October 24, 2017.
4 Clare Dickinson, “AXA IM goes the extra yard with Mifid II research pledge”, Financial News, 14 September 2017.
QuickLook is a weekly blog from the Deloitte Center for Financial Services about technology, innovation, growth, regulation, and other challenges facing the industry. The views expressed in this blog are those of the blogger and not official statements by Deloitte or any of its affiliates or member firms.
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