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Sell-side research producers need to make sure their policies, procedures and controls – plus the supporting technology – will satisfy the FCA that they’re not offering research as an inducement to buy trade execution services. Above all, this means being able to show that charges for investment research are clearly separated from those for trade execution, and that research prices accurately reflect the cost of producing it. The FCA has recently launched a review of how market participants have implemented the MiFID II investment research rules. Both the rules and the FCA review are, on the face of it, focused on the investment managers that consume research.
However, broker-dealers that produce research are also significantly affected, probably for an extended period since it will likely take some time for the full impact (thematic review followed potentially by a revised supervisory approach) to play out.
So what does the investment research review mean for broker-dealers providing both trade execution and research services? And what actions you can take now to make sure you satisfy the new rules?
The MiFID II investment research rules as applied to sell-side research producers
The MiFID II rules on investment research apply to research on a broad range of financial instruments, including equities, bonds and derivatives. Investment managers are required to make explicit payments for MiFID II investment research on those instruments. This is to demonstrate that research is not being offered as an inducement to use the research provider for trade execution. To pay for the research, managers can use either their own resources or those of their clients, providing they comply with detailed requirements on research payment accounts (RPAs).
To enable investment managers to comply, firms providing them with both trade execution and research services are required to unbundle the associated costs by charging separately for those services. The rules also demand that firms providing both research and execution services ensure that the charge for execution reflects only the costs of executing the transaction. The supply of MiFID II investment research, and the charges for it, must not be in any way influenced or conditioned by payments for execution.
While the rules contain no specific requirements regarding the price of research, the introductory texts setting out the rationale for the regime indicate that regulators definitely will consider pricing. It’s clear, then, that allocating valuable resources to investment managers without appropriate charging will not be acceptable. Providing these benefits to investment managers will be seen as impairing the managers’ duty to act in the best interests of their clients.
What will the FCA investment research review focus on?
1. Research pricing
Announcing the review of the implementation of the research rules, the FCA has commented that investment banks cannot offer “unduly favourable terms” for research. It has added that “Any all-you-can-eat research offerings are potentially more prone to fall short of the spirit of the MiFID rules.” Judging by these statements and the explanatory texts accompanying the new rules, the FCA is likely to consider research prices that are less than cost of production to be non-compliant.
2. Cross-asset application
The new rules are being applied beyond cash equities – they affect research on all other financial instruments including fixed income, currencies and commodities (FICC). This represents a significant change from the situation before MiFID II, where the FCA dealing commission rules applied only to cash equity research. The FCA will probably ask sell-side firms to show how they have implemented the requirements, including those on unbundling, in previously unregulated areas of research, such as FICC instruments and also macro strategy.
3. Categorisation of research
The onus is on the receiving firm to determine whether a service should be considered research, and the FCA has stated that any labelling by providers will not automatically mean it can be accepted as such by the recipient. However, an investment manager’s first step will probably be to look at any classification of the services made by the providers. Therefore, the FCA is likely to ask research providers to provide evidence of their approach to determining whether services and materials constitute research or fall under the limited exemption whereby certain items classified as minor non-monetary benefits can be provided without charge. (Examples of items that fall under this exemption include short-term and unsubstantiated market commentary on economic statistics or company results.)
4. Research payment processing and reporting
The sell side will need to be able to process both direct payments from investment managers and payments from the managers’ clients through RPAs, and attribute those payments appropriately. Given this requirement, plus the widespread dependence of investment managers on the sell side for RPA administration, it’s likely that the FCA will explore sell-side firms’ approach to payment processing and RPA administration.
What broker-dealers should be doing about research now
Your firm should be taking action now to make sure that your policies, procedures and controls, as well as your supporting technology and systems, stand up to FCA scrutiny in the areas discussed above. For example, you need to check that:
- you have effectively unbundled your charges for trade execution from those for research, and have done so across the full spectrum of instruments and assets covered
- you have a research pricing model that is based on an analysis of the costs of production and uses this information to determine a minimum price for which the research can be provided.
How we can help with your MiFID II investment research
We can help with all aspects of compliance, and provide an independent view on the adequacy of the steps you have taken so far across the areas outlined above. We will let you know how you’re doing compared with your peers, highlight any areas that need further work, and, if you wish, propose ways to close those gaps.
Get in touch with our research experts to find out more.
