On April 7, 2016, European regulators adopted the first of several delegated acts under MiFID II, the revised Markets in Financial Instruments Directive. MiFID II is set to come into force in 2018.
By now, market participants have become well versed in many key aspects of the upcoming European regulation, particularly those expected to impact trading, like the European dark pool trading caps. However, one of the more critical rule changes under the new MiFID II structure is the unbundling of research and trading commissions.
Unbundling is meant to increase transparency around the consumption and payment of research and prevent conflicts of interest through laws governing trading inducements. Although the topic is broad in scope, unbundling discussions have focused primarily on the more traditional aspects of research, such as permissible forms of payment, the use of CSA’s, and the impact of research coverage on small-cap companies. Questions regarding subsequent impacts to the trading process, quality of execution, and the competition for order flow are fewer and far between, and yet, are equally relevant.
The impact on execution
On the surface, the divorce of research from execution will provide firms with the ability to choose the best trading partners. Additional rules will help address the need for transparency around trade reporting and disclosures in order routing.
In July 2014, the Financial Conduct Authority (FCA) published a review, which stated, “Retail and professional clients are being failed by firms that don’t properly apply best-execution rules when trading on their behalf.” The review also found that firms were often unable to demonstrate proper management of conflicts of interest when using connected parties or internal systems. In a press release, David Lawton, Director of Markets Policy and International, FCA said, “Firms told us that best execution is a simple commercial imperative – yet our review shows many firms unacceptably fail to put their clients’ interests first, undermining market integrity and inhibiting competition.”
General European trading rules are principles based, which means that brokers are not obligated to route to a particular venue – an “Order Protection Rule” does not exist. Therefore, the responsibility and decision behind where an order is ultimately routed lies with the executing broker. At the same time, the current and future European venue structure allows for certain benefits and competitive effects. In Europe, all things being equal, if a venue provides sub-optimal execution, it risks failure through a lack of order flow and decline in market share. Alternatively, venues that continue to innovate and offer quality execution and services succeed.
Unbundling creates an environment for the buy-side that is similar to the one currently enjoyed by brokers with respect to their choice of trading venue. With the power of choice fully resident with the buy-side, the trading and execution landscape inherently becomes much more competitive. The competition for order flow and trade related services will intensify and brokers will place more emphasis on gaining an advantage. To succeed, particularly in the electronic and dark pool space, brokers will need to improve their execution offering through better quality of service and unique product solutions, and convince their clients that their services and execution quality are superior.
Unbundling & Methods of Payment
Asset managers will be permitted to pay for research services in one of two ways: directly from a firm’s own resources, or through a Research Payment Account (RPA), a registered Payment Institution approved by regulators that provides segregated cash management and payment services. Firms using RPAs will be required to determine a defined research budget with each client and disclose details surrounding the charges and payments of research over the period. Most importantly, “the specific research charge and payments made through an RPA may not be linked to the volume and/or value of transactions executed on behalf of the clients.” (Research Payment Accounts are outlined beginning on page 26 of the Directive.)
The notion of divorcing research payments from execution is not a new concept or practice for many firms, but when the use of CSA’s as a form of payment was called into question, members of the industry grew worrisome. Areas of uncertainty still exist with respect to how CSAs will fit into the new regulatory structure. Some believe the directive in its current form allows for the use of CSA’s in a modified form — separate and distinct charges for research and execution. Others believe that CSAs embody an inherent relationship between transactions and payment for research, and will not be permitted.
Nowadays, firms operate and trade in multiple asset classes and regions. Therefore, a U.S. based global trading firm could consider applying the most stringent rules across all trading regions that impact the firm. From a compliance standpoint, the trading rules of one region alone are complex. Therefore, the decision to uniformly apply rules across regional business units, where possible, could prevent unnecessary breaches in regulation and reduce their overall operating costs.
More recently, several buy-side firms have claimed that absorbing the cost of research internally is the most likely outcome. Structurally, paying for research outright is simpler versus introducing an entirely new method (RPA), a method that could add complexity and costs to their existing business model. Having said that, as firms begin to absorb more research costs under the new regulatory structure, they could start bringing in more research operations in-house.