Establishing a new approach to paying for equity research

The UK Financial Conduct Authority’s (FCA) recent feedback statement was, in many respects, a damning rejection of much of the European Securities and Markets Authority’s (ESMA) MiFID II technical advice on payments for equity research. The UK regulator continues to argue that client commissions must never be linked to research payments, and holds that Commission Sharing Agreements (CSAs), by themselves, are insufficient for managing the process.

However, instead of forcing unbundling, with all its potentially damaging consequences, industry participants should meet regulators’ demands for increased transparency by continuing to build on existing tools and capabilities. The FCA itself has acknowledged that existing platforms to administer CSAs could be further developed and used in the new environment, assuming that the buyside changes its practices and properly manages the conflicts it is exposed to. But it is still not clear what this means in practice.

Only two of the 17 investment firms reviewed by the FCA last year were found to have satisfactory practices in place for handling the allocation of dealing commissions. While this is a shockingly low number, it does highlight the fact that some firms have been able to use existing tools to demonstrate a level of transparency and accountability that satisfied one of the world’s most stringent regulators.

ESMA’s MiFID II technical advice proposes that research can be funded from a “ring fenced” research account through a specific monetary charge to each underlying fund. Alternatively, research could be funded directly by the investment manager, which is similar to a fully unbundled model.

The burden of implementing ESMA’s new advice will fall primarily on the asset managers, who will be required to determine budgets for research and agree with their fund clients how much research they want to purchase, what to pay for it, and be able to show an audit trail for the payments. If there is a surplus at the end of the relevant period, the balance could be either refunded to the client, or rolled over to the next period.

CSAs are specifically designed to bifurcate execution and research procurement decisions. As a result, the regulators’ ultimate goal of greater transparency can be met most simply through this route.

Looking ahead, under MiFID II it is likely that a new “enhanced” CSA model will emerge -harnessing the benefits of contemporary CSAs and modifying them to meet regulators’ new demands. CSA aggregators, which roll up this activity and relieve the administrative burden placed on brokers and investment managers, will play an important role in the new landscape.

However, investment managers have the option not to leverage the CSA framework. They could instead work with each client to fund the client research account or fund a research account themselves. Under these scenarios, a CSA aggregator could still provide the tracking, audit and payment tools needed to support the investment manager’s research program.

The industry would benefit from regulators clarifying how they would like the requirements to be met. Market participants could be compelled to use a pre-determined approach in order to set a benchmark for compliance and simplify the process for all involved.

Championing best practice through the use of enhanced CSAs presents a viable alternative to an enforced unbundling regime. The latter would inevitably be littered with unintended consequences that could result in a reduction in research coverage, the creation of a environment that disadvantaged smaller investment managers and brokers and, ultimately, made it more difficult for companies to access to the capital markets.