What are the global implications of MiFID II research payment rules?

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The MiFID II regime will have ramifications for buy-side global asset managers and sell-side research providers relating to use of dealing commissions and cost allocation for research expenditures, writes William Yonge, private investment funds partner at Morgan Lewis.

The most controversial area of the EU's Markets in Financial Instruments Directive II (MiFID II) reforms, in effect on
3 January 2018, relates to the methods of payment by portfolio managers for research produced by the sell-side. 

This reform had long been foreshadowed in the UK by the Financial Conduct Authority (FCA), which has taken a consistently hard line on the arrangements UK portfolio managers have in place for managing the conflicts of interest that arise from using transaction commissions to pay for research. 

MiFID II builds on the existing MiFID I inducements standards. For portfolio managers, it bans the receipt and retention of fees, commissions, or any monetary and non-monetary benefits from third parties other than qualifying "minor non-monetary benefits" (MNMBs). 

That prohibition is elaborated by provisions which identify acceptable MNMBs, for example, short-term commentary on the latest economic strategies or company results, or third-party written material that is commissioned and paid for by a corporate issuer to promote a new issuance; and a bespoke regime to allow portfolio managers to receive research without it constituting an inducement.  

Research received from third parties is not regarded as an inducement for a portfolio manager if, in essence, the receipt of research does not create a pecuniary benefit to the portfolio manager because the research is received in return for either: 

• Direct payments by the portfolio manager out of its P&L; or 

• Payments from a separate research payment account (RPA) controlled by the manager and subject to governance requirements. 

It is clear that the charge may be paid for out of dealing commission provided that the research is priced separately ("unbundled"). 

The detail about the exact form of an RPA and how it will interact with a CSA-style funding mechanism are yet to be determined by the industry.  

The new regime does not distinguish between equity research and fixed income research.

The FCA concedes that the regime, in the context of fixed income research, will be more challenging to operate as fixed income research has historically been paid for out of the spread. 

Competitive disadvantage

The FCA proposes to "gold-plate" the regime by applying the same standards to all forms of investment management activity notwithstanding the lack of a mandate to do so under UCITS or AIFMD.

If other EU regulators decline to follow suit, then the UK will have put itself at a competitive disadvantage. 

Silverfinch launches MiFID II data solution

One of the difficulties arising from "unbundling" is that research provided to the portfolio manager can benefit many clients even if some of those clients do not agree to pay for the research or only agree to pay a small amount compared to others.

Therefore, some clients could reap the benefits of research while leaving the burden of paying for it to other clients - AKA "free riding".  

It will be a challenge for managers to consider how best to allocate research costs fairly in such cases.

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