Since our last post, the European Commission has finally published the long awaited Delegated Act (DA). The first point to note is that the Act was published in the form of a directive and not a regulation. This means that every National Competent Authority (NCA) in Europe must interpret the directive in its own way and incorporate it into national regulations. In other words, there is a certain amount of leeway as to the exact means of implementing the directive’s aims by each member state. In case you missed the final text, the released version can be found here.
The Delegated Acts explained
The published DA clarified that a Research Payment Account (RPA) can in fact be funded by a ‘separately identifiable research charge’ alongside a transaction commission [Article 13 (3)]. This was one of the most widely-awaited clarifications in the directive, as it confirms that, conceptually, a Commission Sharing Agreement (CSA)-style funding mechanism may be used to fund an RPA.
The EC have stipulated that when an investment firm uses a transaction to fund an RPA, then a number of conditions must be met. These conditions can be grouped into three main categories: Funding, Research Quality Assessment, and Reporting:
- The RPA must be controlled by the investment firm;
- The RPA is funded by a specific research charge to the client;
- The investment firms set and regularly assess a research budget as an internal administrative measure;
Research Quality Assessment
- The investment firm is held responsible for the RPA;
- The investment firm regularly assesses the quality of the research purchased, based on robust quality criteria and its ability to contribute to better investment decisions;
- The investment firm shall provide the following information to clients:
- On an ex-ante basis (before the provision of an investment service to clients), the investment firm must provide information about the budgeted amount for research and the amount of the estimated research charge for each client [or fund];
- On an ex-post basis, the investment firm must provide annual information on the total costs that each [client or fund] has incurred for third party research.
These additional requirements are what makes an RPA different from a CSA.
What’s the difference between a CSA and an RPA?
We have not assumed that a CSA (as we know them today) automatically translates to an RPA. To understand why, we must consider each of the conditions above in the context of today’s CSA arrangements.
- Control – CSAs are usually controlled by the Asset Manager i.e. they exercise direction over the funds. We interpret this to mean that a trade-by-trade reconciliation would need to be conducted in order to provide evidence of such control. We have heard of cases where: (a) an investment firm accepts a broker’s version of a CSA balance (without reconciling) at month-end; or (b) A reconciliation is conducted to confirm total month end balances match (not trade by trade); or (c) one party derives their universe of eligible trades solely by reference to the other party’s data. We believe all such practices would fall short of the requirement for the investment firm to be in control of their RPA.
- Funding by a specific research charge – CSAs comply with this requirement at a basic level; every eligible trade represents a research charge being applied to the transacting fund. It is common for CSA agreements to detail the eligibility criteria that apply to the given arrangement, often down to the level of specific funds to be included or excluded from the agreement. When a fund is excluded, this is only recognized post-trade and at that stage, the broker keeps the full service rate and the CSA is not credited. We believe this practice might need to be reconsidered when operating within the bounds of an RPA. As an observation, it is worth pointing out that from a reconciliation standpoint, most aggregators usually consider CSA eligible trades only, and therefore any ineligible trades are not reconciled.
- Research Budgets – CSA arrangements (as we know them today) don’t typically consider a research budget. To understand this requirement, it’s important to be clear on the level at which investment firms must now manage their budgets. It is our interpretation that the DA requires budgets to be managed at the firm level. There are various views on this, but a number of compelling arguments supporting the firm-level interpretation have been made by contributors to a new LinkedIn Group dedicated to this topic – click here to learn more. It also appears that the newly-published DA appears to have softened the requirements for budgeting. The latest text states that ‘firms should regularly assess research budgets as “an internal administrative measure”’. Our reading of this is that budgets are not managed at the client or fund level. Investment firms must create an estimated research charge for every fund or client; this charge is an estimated or pro-rated allocation of the (firm-level) research budget. Our understanding is that there is no obligation on the investment firm to notify or obtain approval from a fund or client in the event that the fund- or client-level estimated research charge is exceeded during the course of the year. The investment firm would however have to notify its clients if the firm-level research budget were breached. The summary is that the requirement for budgeting is new and is something that investment firms will need to consider in more detail over the coming months.
- Responsibility – CSAs are already the responsibility of the investment firm, however the line separating the investment manager and the broker (or aggregator) is not always well defined. As an example, it is fairly common practice for brokers to hold CSA funds on their own balance sheets, despite holding these funds on an asset manager’s behalf. We don’t believe such practices will be acceptable in the event that a broker wishes to administer an RPA on behalf of an investment firm. RPA administrators will need to hold research funds in a separate ‘ring-fenced’ client account. This would ensure that the investment firm (or ultimately their end clients) are not left out-of-pocket in the event that the RPA broker defaults.
- Research quality assessment – Firms using CSAs are not currently under a regulatory requirement to ensure the research they procure complies with any level of quality assessment. This is another new requirement, and means CSAs used in isolation, without a robust research evaluation platform, may not be considered compliant. We will drill into this requirement in more detail in a separate blog post to follow.
- Reporting – CSAs don’t currently have any regulatory reporting requirements either on an ex-ante or ex-post basis. The UK has adopted a client reporting standard
(Level II Disclosures) following the Investment Management Association’s best-practice guidance on the subject. It appears that the new reporting requirements within the DA will supersede the Level II Disclosures in the UK. The important consideration for investment firms is that existing CSA administrators may struggle to deliver this requirement because they (i) typically only see eligible CSA trades (ii) may not see other asset types (iii) don’t have visibility of priced research consumption by fund (iv) don’t have visibility of the research evaluation process, and how this links back to funds or clients.
In conclusion, we believe that in Europe, CSA’s will most likely require a tighter control and governance framework in order to become RPA compliant. Even when compliant, the role of the CSA is limited to providing funding, and does not address the reporting and quality assessment requirements of the new regulation.
We believe that CSA’s and RPA’s may in fact coexist in Europe. The number of CSA and RPA providers that a firm retains is unlikely to be consistent across the industry. Every firm is likely to make this decision based on a number of factors that are relevant to their firm.
As an example, firms will decide on the most appropriate approach to funding their RPA. We believe there are two methods that asset managers can choose to fund an RPA: (i) the transactional method; and (ii) the accounting method. The transactional method uses a research charge that is included alongside a transaction (or trade) to fund an RPA. The accounting method on the other hand uses a fixed charge that is applied to each fund and is most often accounted for as a daily accounting “accrual”. This daily accrual would eventually be transmitted to the asset managers chosen RPA administrator(s) at a pre-agreed frequency (often monthly or even quarterly) so that the RPA administrator can complete all payments for research from this research balance.
However, it is noteworthy that solving the funding challenge alone does not make a firm RPA compliant. The investment firm must additionally provide evidence that they have regularly assessed the quality of research they’ve consumed against agreed quality criteria and have ensured that they have only paid for research that has helped the firm to make better investment decisions for its clients. They also must have the ability to provide reports to clients detailing where research dollars have been spent and how these amounts were justified. A fully integrated research evaluation and consumption tracking solution that considers a holistic view of research spend across the firm (including other asset types) will eventually be required.
Amrish Ganatra is a Managing Director at Commcise Software Ltd. Commcise provides an innovative fully integrated cloud-based Commission Management solution that incorporates automated reconciliation, invoice management, commission budgeting, service history or consumption tracking, research evaluation (“voting”), commission management, share of wallet reporting and accounting functionality.