Now that MiFID II has come into force, we look at what processes ESMA expects asset managers to have in place to demonstrate transparency and robust research valuation.
On 10 November 2017, ESMA published the latest version of its Q&A designed to provide clarity on the application of MiFID II and MiFIR requirements. The section on inducements (updated in early April) outlined options for firms to ensure that the allocation of their research budget to third-party providers, and the determination of the payments made from that budget, are in the best interests of the firm’s clients.
ESMA observes that firms’ research policies need to explain how the related costs can be allocated in a manner that is fair to the various clients’ portfolios. This is an approach that Commcise facilitates through our fair allocation methodology, enabling firms to clearly demonstrate that clients are directly deriving benefit from the research that has been consumed. To do this effectively, an asset manager must track both research funding (whether from clients’ or its own resources) and consumption, at a highly-granular level. These elements are then allocated appropriately to funds through a sophisticated fund-level, fair allocation research accounting mechanism that respects funds’ relative sizes and the investment strategies with which they are aligned.
MiFID II demands that firms pay for research either as a direct payment from their P&L or from a ring-fenced research payment account (RPA). We have customers who have chosen the former route but still want fund-level research budgeting, cost allocation and reporting because of the challenges of setting a global research policy.
Some firms have committed to paying for research directly, only for clients who are subject to MiFID, while continuing to fund research payments alongside commissions for the rest of their client base.
Even where firms are using a mixed model, the ability to demonstrate that research charges are being fairly allocated to clients is becoming best practice – for example, we are seeing US firms, who are not directly affected by the ESMA guidance, choosing to adopt the methodology of fair allocation of research costs to the underlying funds.
ESMA recommends that budgeting should take place at the outset of the research procurement process in order to determine the appropriate level of the research charge that is in the best interest of clients and ESMA also advises that budgets need to be regularly reviewed.
This budget-setting process should be undertaken in a way that is not linked to previous trading volumes or previous research payments. Linking payments to inputs and services should mitigate conflict of interest risk that research payments to providers could be perceived to be rewarding other non-research benefits.
Firms must also ensure there is a robust control framework where senior management take responsibility for ensuring that research budgets are managed and used in the best interests of their clients, including a clear audit trail of the payments made to research providers and controls around quality.
Using a rate card-based approach can enable firms to negotiate ex-ante expectations of payment levels with research providers for an expected service level. Furthermore, this allows asset managers to demonstrate they have applied appropriate rigour and control in determining actual payments to providers for the services actually received.
ESMA has further guided firms to consider using a rate card based approach if they wish to alter a payment to a provider following the consumption of research. It states in the response to Question 10 of the June Q&A: “At the end of the period, based on actual services received, the firm may adjust the payment made to the research firm in a proportionate and predictable manner based on those criteria”. At a recent conference, the FCA’s Adam Wreggelsworth also indicated that he expected this to apply to firms that choose to pay for research out of their own resources.
The main observation to draw from ESMA’s guidance is that firms that choose to pay for research from P&L are not absolved from the obligation to demonstrate – through a robust methodology – that they are paying appropriately for research.
The importance of establishing a research policy that can stand up to the closest regulatory scrutiny is reflected in the evaluation and reporting solutions Commcise has developed for investment management firms. Helping these firms ensure that trading activity is unbundled from research fees, and that research charges are allocated fairly, also enables them to manage the entire investment research process.