This article first appeared in FOW on July 12, 2016
Through the Markets in Financial Instruments Directive (MiFID II), regulators are seeking greater transparency across the trading process, part of which may entail separating the costs of trading activity from research spend, in order to gain insights on the actual cost of the research. As a result, firms are looking to make changes to their trading and front-office operations, as well as their post-trade processes.
Historically, buy-side firm dealing commissions have been bundled with the cost of research into just one payment. Under MiFID II, however, asset managers could be required to pay for the research separately and directly from their own P&L, which would remove any conflict of interest between execution and access to research. With the new arrangements, buy-side firms would set up separate client accounts that would be solely used to pay for research within a strict, pre-agreed budget. This ‘unbundling’ requirement was clarified in a Delegated Act published by the European Commission back in April 2016.
At present, most buy and sell-side firms use Commission Sharing Agreements (CSAs) as the preferred method of separating research payments from execution commissions. These agreements allow brokers to collate research payments and then to hold the balance to the client’s order. These payments are reconciled with the buy-side firm at the end of a specific period (e.g. monthly, quarterly), with the broker paying relevant research providers from the funds accumulated in the research budget. With the MiFID II unbundling mandate, it is likely that CSAs may still have a purpose, but will need to be supported with a Research Payment Account (RPA) – separate accounts funded by client money allocated specifically for the purpose of research payments. Moreover, since MiFID II encompasses all asset classes, for brokers, the new requirements will mean the need to provide accurate research pricing by specific asset class.
The new unbundling rules will certainly have far reaching implications for post-trade processes. In the current set up, bundled execution and research charges are an intrinsic part of the total cash being settled and are not currently entered separately at the point of trade confirmation. After the implementation of MiFID II, it is quite possible that these charges will need to be quoted separately during the trade confirmation phase. This change will likely create issues for the buy-side firms who will need to consider a number of factors before implementing changes to their post-trade processes. Some firms may choose to return to execution-only charges at the trade confirmation phase and bill for research independently. Others may choose to agree to separate the charges and include them as distinct elements at trade confirmation. If they opt for the latter, representation of the charges at the point of trade confirmation will of course require careful deliberation since execution costs are presented as a percentage, while the research charges may be at a fixed cost. In addition, analysis of research budgets and agreements of the buy-side firm’s underlying funds will be required. Firms will have to consider the impact of having to identify these diverse components at the confirmation level as multiple funds are often attached to a single transaction.
From a sell-side perspective, pricing their research will likely be the first challenge they face, given that all asset classes will be covered under the scope of MiFID II. Specific challenges are anticipated around the pricing of fixed income research given that the concept of execution commission or research at the confirmation level has not previously existed. Furthermore, some buy-side firms may require their broker to separate charges presented at the trade confirmation level, while others may simply choose alternatives. Another issue is that research charges may differ from one buy-side client to another which means that complex data tables will need to be produced to maintain and capture the charges. Brokers will therefore need to design a solution which can be customized to accommodate the varying needs of their clients while remaining compliant with the MiFID II rules.
While the majority of market participants are fully aware of the changes that will need to be made to their post-trade processes to comply with MiFID II, few fully understand how far wide ranging they are set to be. The unbundling of research payments and the system changes that need to be made at a confirmation level are just one example. The industry should use the extra time recently granted by regulators to understand exactly what is required of them and ensure they have the requisite processes in place by the 3 January 2018 deadline.