MiFID II: CSAs, RPAs and Specialization



Those who have been in the financial services industry since a time before acronyms like MiFID were in vogue likely recall a time when building a ‘financial supermarket’ was the new strategic plan. In the 1990s, combining brokerage, banking and insurance companies under a single umbrella to provide one-stop shopping for all things financial was heralded as the future of our business. Introduce a repeal of Glass-Steagall and it was off to the races.

Things have certainly changed since then. The anticipation of the European Union’s Markets in Financial Instrument Directive II (MiFID II), and a continuing move toward unbundling in the U.S., has had a significant impact on institutional research, trading and investment management. Today, the buzz words transparency and specialization now go hand in hand. It is now commonplace to see investment managers reduce brokerage lists and engage a core group of strategic partners who can provide expertise in a single discipline or two – notably, research and execution, but also in services like compliance and regulatory consulting, TCA, and research valuation. The days of institutional investors seeking a one-stop shopping solution are long gone.

MiFID II and the provision of research in Europe

MiFID II has outlined a number of new requirements for managers seeking to pay for research. Most meaningfully, the new requirements will put an end to bundled trading and provide greater clarity around the cost and valuation of investment research.

Transparency, of course, is one of the goals of MiFID II, along with providing more robust consumer safeguards, increasing competition and improving the ability to seek best execution. The key requirements of MiFID II regarding the provision of research in Europe are:

  • Establishing a Research Payment Account (RPA) to track and administer an investment manager’s research spend. This account, to be legally controlled by the investment manager, may be funded from a manager’s own P&L, from an explicit fee charged to their managed accounts or via commissions generated from their trading.

  • Unbundling all research, including proprietary, sell-side research.

  • Enforcing new budgeting protocols, in which managers must establish research budgets for each investment ‘strategy’, provide ex-ante notification to clients regarding their research budget, obtain written approval on any budget changes, and maintain comprehensive oversight and controls on this process and a thorough audit trail on their research valuation and payment processes.

While these changes may seem to be operational in nature, they will drastically change the manner in which business is transacted between the buy and sell-side and will recast the roles of many industry players including forcing bulge bracket firms and all bundled brokers to price their research in a more granular manner.

In our conversations with clients, brokers and research partners we sense that many of the details about workflow and responsibilities are still being determined. Yet with the implementation of MiFID II less than a year away, the industry is getting to the point where all players will need to start taking action, if they haven’t done so already.

MiFID II and its impact in the United States

Regulators, brokers and managers in the United States are carefully monitoring the impact MiFID II will have both at home and abroad. The SEC has not made any changes to Section 28(e), which governs research spending, nor have they provided any further interpretive guidance regarding the use of commissions.

Nonetheless, U.S. firms are aware that they will be impacted by MiFID II.

The situation presents U.S.-based global investment managers with an interesting conundrum. Managers domiciled in the U.S. are subject to U.S. regulation, but their UK and European based affiliates are not. And MiFID II rules regarding inducements and research are very different than those currently in place in the U.S.

For U.S. managers, MiFID II regulation simply can’t be followed to the letter. The concept of a Research Payment Account is unique to the UK and Europe – it is not a legal construct in the U.S. Some other key differences between the two regulatory regimes include:

  • Research is defined differently in the U.S. than it is in the UK. It is commonplace for U.S. managers to use commissions to pay for corporate access, to attend investment related conferences and seminars and to acquire data sources and analytic tools that are used to inform their in-house research process. None of these are considered ‘permitted services’ as defined in the FCA’s Conduct of Business Sourcebook, and thus, are not available via trading commissions in the UK.

  • U.S. Managers may ‘cross-subsidize’ payment for their research services across all of their managed accounts, while European managers will soon be responsible for having separate research budgets and accounting for each different investment strategy.

  • Full unbundling will soon be the rule in the UK and Europe, but will not be a legal requirement in the U.S. This raises a few of questions for U.S.-based brokers, namely:

    • Will brokers choose to move all ‘research’ commissions into a segregated CSA account, receiving payment for their own research at a later date, only pursuant to client approval?

    • Will brokers willingly price their proprietary, bundled research for managers who ask?

  • Many brokers and managers have expressed the concern that a cash payment made to a U.S.-based broker from an RPA account may introduce regulatory risk relating to requirements under the Investment Advisors Act of 1940. While no-action guidance regarding this topic is currently in motion, a final decision will eventually have to be rendered.

What Investment Managers can expect

While MiFID II does present investment managers with a new set of challenges, none of the differences between the regulatory environments will prevent a workable solution from being developed. When MiFID I regulations were first announced, both buy- and sell-side players shared real trepidation about its impact on their business. However, the regulatory change came and went while players on both sides of the fence successfully navigated the changes and new requirements. The same will likely happen now.

U.S. based global managers will need to decide how to administer businesses that straddle two or more regulatory regimes. While some may choose to ring-fence their UK and European business, others will choose to run a single, global business and do their best to follow the ‘spirit of the rules’ defined in MiFID II while adhering to local regulatory requirements.

The conventional wisdom is that many U.S.-based global managers will choose the latter, as they may prefer a more conservative approach, in part driven by demand from their overseas clients. Ultimately, only time will tell which features of MiFID II policy might be adopted by managers in the U.S. and elsewhere, and how U.S. and other regulators may add to the conversation.

Amid this uncertainty, larger investment managers, bulge bracket firms and key industry thought leaders will chart a path forward. They will establish processes and protocols and it’s likely that the rest of the industry will eventually adopt them. Over time, brokers and other industry providers will continue to evaluate the opportunities and challenges that emerge from a new regulatory landscape.

Many industry consultants have expressed concern that regulatory change, technology, and capital costs have hampered larger brokers, forcing them to rationalize business lines, reduce research coverage and establish minimum client profitability requirements. These concerns are not new, of course. Larger industry players have wrestled with the ebbs and flows of the economy and capital markets long before MiFID II came about. Good brokers will map out a strategy and move forward. And it is becoming clear that a move toward specialization has been underway for some time, and most brokers will no longer try to be all things to all people.

Tourmaline Partners view on commission management

While the implementation of MiFID II will disrupt existing protocols around the provision and acquisition of research, we expect that the use of commissions to fund RPAs will be the preferred choice for most UK and European managers while the use of CSAs as a research funding vehicle in the U.S. will continue to grow.

There will be a continued trend towards more clarity around the price and valuation of research and greater unbundling as well as continued adoption of technology and data in the buy-side investment process, which will lead to an increase in the number and types of firms providing investment input.

These trends will fuel outsourcing and specialization. Managers will most likely choose to rely on a smaller group of select industry partners in core businesses. Expect shorter lists of trading counterparties and a greater focus on key strategic partners who can provide specialized solutions around research and trading, complemented by high levels of client service and industry expertise.

Commission management is a part of the core offering of Tourmaline Partners. We will continue to observe and comment on these trends and advise our clients regarding trading solutions, best execution and the use of commissions in both the U.S. and European markets to help them better manage an unbundled world.

To learn more about Tourmaline Partners and our commission management capabilities, or to hear our thoughts on how MiFID II will impact the industry, give us a call.