MiFID II regulation in Europe and Commission "unbundling" in the rest of the world is driving significant change in the commercial model of full service broker-dealers and investment banks. Regulation requires all research consumed by an asset manager to be "paid for" in explicit terms, rather than "bundled" in the brokerage commission (as it has been for years). Any research delivered (from research providers to asset managers) without an attached price tag will be seen as an "inducement to trade" by the regulators and therefore considered illegal under the new regime.
This move to explicit pricing of all research and related services is bringing profound changes to the broker-dealer and asset management industry. Being able to manage entitlements (for clients), and then delivering on that specific mandate will become increasingly critical for all broker-dealers and banks in the client-service working relationship of the future. While MiFID II may only specifically apply to operations within the European Union (UK remains a player despite Brexit), its relevance to both service providers and asset managers cannot be under-estimated in the rest of the world. Asset Managers may choose the most stringent regulatory environment as a benchmark to streamline their compliance function and may even see some of these requirements as best practice to remain competitive in the market place. If the latter plays out in reality, then all broker-dealers will be forced to make changes to their working practices.
When it comes to investment research services and its commercial model; the regulators have been very clear in terms of their objective to separate research payments (from the buy-side to the sell-side) from trading activities (of the buy-side). The rationale being applied - Why should the cost of research (or the payout for research services) have anything to do with an asset manager’s trading behavior?
Separation of research payments from trading activities at a buy-side organization has huge implications for broker-dealers and banks when it comes to engaging their institutional investor client base. Going forward research consumed by the asset manager has to be “paid for” in explicit terms and any research consumed that does not have a price tag (or has not been paid for) will be seen as an “inducement to trade” from the broker to the asset manager and therefore considered illegal.
From a monitoring perspective, the regulator is particularly keen to ensure there is a clear separation of research spends (at an asset manager) from its trading activities; and in turn this practice is accountable over any length of time.
Investment research has to fulfill certain definitional criteria in order to be eligible for being considered as a “paid” offering. Investment research has to be “substantive” in order to justify being chargeable to the asset manager. Substantive investment research has to mean “any value-add views that in one way or another inform the investment decision”. Under the proposed ruling and definition, it brings within the net not only single-company corporate research, but also economics, fixed income, currency, commodity and strategy research.
Items that fall outside of this “substantive” definition relates to items of “minor, non-monetary benefits” which includes, previews, earnings updates, news comment etc. However, the latter can be debated, as there are some news events that warrant a comment and have a significant bearing on stock performance and therefore not “minor, non-monetary” in benefit. Therefore such eligibility criteria on what constitutes “substantive” and what is mere “news reporting” may go through a process of iteration to remove regulatory ambiguity.
Under the MiFID II guidelines for research consumption and paying for it in explicit terms, the challenge to businesses both at the producer and the consumer level can be characterized as follows:
Putting a price tag on research and the methodology that would drive the “price” conversation remains far from standardized in the market place currently, as historically research has never had an explicit price tag associated with it.
Having put a price tag and ensured the subscription plan (driven by coverage and number of recipients), one has to put in place the appropriate monitoring capability to track consumption behavior to aid regulatory compliance as well as justify successful renewals on the subscription plans put in place.
All research spends at an asset manager in the post-MiFID II world has to be paid out of a pre-set research budget (managed via a Research Payment Account (RPA) framework). The latter ensures there is a separation of research payments from trading activities. All such activities in terms of what is being paid for and how research payments to one service provider from another are being justified for differential price terms, requires elaborate record-keeping and reporting.
Figure 1 below highlights two possible avenues open to asset managers to fund their RPA accounts in order to make research payments to service providers (i.e., broker-dealers, investment banks and independent research providers). At the moment, there seems to be increasing momentum in Europe to adopt the Enhanced CSA (Commission Sharing Arrangement) method to fund an RPA account. In other words, using commission dollars to fund the RPA account, in line with the pre-set RPA account budget at a fund level.
The second method – Client Contribution Method – also commonly referred to as the “Swedish Model” involves a separate charge to the AUM at the asset manager to fund the RPA. This method is increasingly losing its edge given the competitive nature of the fund management industry and trying to secure a separate contribution (to fund the RPA) at the time of soliciting funds (apart from the regular management fee), may be tall order, especially given the competitive pressures being felt from passive fund management offerings.
France has clearly come out in support of the Enhanced CSA method to fund its RPAs and Germany has decided to follow the French on this front.
Within in the UK the direction is less clear as many fund managers are contemplating paying for research using their P&L. However, this may not sit well with many global brokers and investment banks, as many have voiced the view that they will not be able to service clients that wish to pay using hard dollar checks. Additionally, there was a common misconception at many asset managers that deciding to pay hard currency checks for research will absolve them of their MiFID II compliance requirements around and research and related services. That is not the case and the monitoring and accounting obligations will still remain.
A research service provider has to successfully answer four key questions
The first two questions are easier to answer relative to the third question. The first question relates to highlighting the research that is “substantive: and therefore can be priced to the client base. This is clearly a case of fulfilling a check-list (regulator introduced) in order to be able to justify putting a price tag on the research (product) on offer.
The second question (on differentiating between “product” and “service”) relates to a slightly more complex working to differentiate the pricing of research between the product and service component of the value proposition. This question requires further in depth assessment to bring out some of the granular nuances of it working out in a “real world” client servicing environment. When you speak to an asset manager, you often here that the published research consumed by them account for no more than 25-30% of the overall payout for the overall research service. “Research Service” in this case includes accessing the published product; corporate access accounting for 30-35% of the overall payout; followed by analyst access and active sales coverage (accounting for the balance 35- 40% of the payout). In other words, the level of service (tiered to each wallet opportunity on the buyside) that a sell-side intends to commit to a client (buy-side), will drive the overall payout. We highlight the tiered service model in some detail in Figure 2 below.
The third question (i.e., how much do you charge for your research – product or service?) has had various references to an ala carte menu-based pricing plan wherein in each report can be attached a price tag and available on a download basis. If one were to take this management consultant type approach to research delivery and entitlements wherein its left to the prospect to identify a report as a specific need and then decide to download the report, having paid for it; I believe the industry would struggle to sustain itself. Most people will agree that “research is not bought, its sold!” on that premise a price per report approach may not provide the necessary commercial sustainability to build a successful client engagement model over time. At ANALEC, we believe Investment Research still needs to be delivered proactively to clients based on their interests and subscription boundaries; under the new regime.
It’s the final question on assessing investment impact or “service efficacy” in the investment decision making process (at the asset manager), that leaves many service providers (i.e., brokers) and consumers (i.e., asset managers) yet to create real consensus on the way forward. The measure of “service impact” is an ex poste consideration; in other words an assessment after the consumption of the product (or service) has taken place. Recognizing this as an important component of the overall research price or payout model is essential to maintaining an incentive structure for service providers to strive harder to deliver on-going value in all client relationships. This ex poste consideration in the overall payout model is somewhat akin to the current ex poste broker review process for deciding payouts. However, we expect changes to its working mechanism.
Price is what the service provider wants and value is the “price” the asset manager is willing to put on it. The value assessment at the consumer end is primarily an ex poste assessment as it implies an assessment of that research (or research service) to the extent to which it positively aided the investment decision-making process at the asset manager.
Ultimately the convergence between price and value emerges (between service providers and asset managers) when the ex-ante pricing is combined with an ex-poste component to reflect an incentive payment to positively impact the investment decision-making process. We believe such an hybrid pricing arrangement is important to incentivize service providers to strive harder to add value in the investment decision-making process at an asset manager. While some may argue such an ex-poste consideration takes us back to the old regime, we would argue it does not, as it still requires being paid out of the pre-set research budget in the RPA; and fulfills the requirement of separating research payments from trading.
For most broker-dealers, we believe the future client service and engagement regime will reflect something along the lines illustrated in Figure 2 above. Client will select their research needs (i.e., drive their published research entitlements from a particular broker-dealer) from a particular brokerdealer; then will go onto select the level “active coverage” or “service they wish to receive as highlighted above in the Research Service component. Both Research Product and Research Service as highlighted above to have an ex ante price tag attached to it based on coverage and level of service. The final component (i.e., Investment Impact) will be derived by the “post reform” broker review process, which looks to reward service providers that are doing a better job than others.
MiFID II dialogue has had dis-proportionate attention on the equities trading and research world however it applies to all forms of trading in financial instruments and markets (which includes Fixed Income, Currencies and Commodities). Most fixed income instruments are not traded in the way equities are traded; wherein the buy and seller pays a brokerage commission to the intermediaries. Trading across bonds, currencies and commodities are conducted on trading spreads (between bid and ask) and it’s the spread that delivers the commercial revenue model to the brokers and banks. Under MiFID II all research and related services consumed by the asset manager have now got to be explicitly paid for as a separate line item. This raises the risk of raising the costs of fixed income trading as now asset managers have to pay extra for the research services consumed.
According to various industry players, it is estimated that the cost of research (in the fixed income space) is around 5-7% of the fixed income spread. If this is the case and research has to be “paid for” in explicit terms, it may either squeeze the spread; or force asset managers to withhold 5-7% of the spread to pay for research. We believe fixed income research will move to some form of “nominal pricing” model, with little impact on spreads in the near-term.
Speaking to a few fixed income desks, they believe pricing for research will be nominal, purely to be compliant. Additionally, they stated that their fixed income research is used within their broader bank (internal consumption) for which they will have charge-backs to other internal business units and be left with a much smaller amount to recover from the asset managers. More on this space for sure!
Undoubtedly there is a lot to digest here. More importantly, broker-dealers and banks have to relook at their technology footprint and capabilities within their research organization and client servicing (“sales & trading”) space in order to be able to (a) be compliant of MiFID II directives; or (b) adopt best-practices to more effectively service asset managers who are moving to a MiFID II aligned broker review and evaluation process. In this respect, our vision on the client service model as laid down in Figure 1 and Figure 2 above requires revisiting technology decisions in the research authoring, workflow, compliance and content distribution space; as well as CRM capabilities in the sales and trading domain, to boost service relevance and not fall foul of the “inducement” provisions.
While there is a MiFID II strict deadline of 3rd January 2018 for all European asset managers and broker-dealers; we believe there will be knock-on impact on other jurisdictions (especially the US) given the global nature of money management. So the challenge is an immediate challenge that requires adequate attention at all broker-dealers and investment banks.
