Under the new regulations in MIFID II, asset managers are faced with difficult choices on how best to implement the new provisions. In this article, we explore the advantages and disadvantages of the three funding options for research payments available under MIFID II.
MIFID II is due to come into effect from January 2018. After this date, if a European asset manager chooses to use their clients’ funds to pay for research, then they will have to meet a number of additional requirements in order to comply with the higher transparency, governance and control standards being introduced. The main such requirement will be to use a Research Payment Account (RPA) to pay for research expenditure. At present, there are three options available to asset managers:
- Use the “Transactional Method” to fund an RPA, incorporating commission sharing agreements; or
- Use the “Accounting Method” to fund a RPA, setting up a separate research charge to clients; or
- Pay for research themselves out of their own P&L.
This article aims to consider the pros and cons of each of these methods.
The Transactional Method
The recently published Delegated Acts (DA) clarified that it is possible to fund a RPA via transactions. Article 13 Paragraph 3 states: “Every operational arrangement for the collection of the client research charge, where it is not collected separately but alongside a transaction commission, shall indicate a separately identifiable research charge and fully comply with the conditions in paragraph 1, points (b) and (c)”. The Transactional Method, as the name suggests, is where an asset manager collects a research charge from their clients alongside a transaction commission. The implication is that it is possible to fund research expenditure using a Commission Sharing Agreement (CSA)-style approach. It should be noted that an RPA and CSA differ in many ways – this has previously been explained here.
There has been much confusion about RPAs because industry participants have always understood that RPAs can only be funded using the Accounting Method. This was the case until the Delegated Acts were published in April 2016, after which it became clear that transactions could in fact be used to fund a RPA.
Why use transactions to fund a RPA?
There are a number of benefits to using a transaction for fund a RPA:
Challenges with using a transaction to fund a RPA
The table below describes a number of challenges with using a transaction to fund a RPA.
The Accounting Method
The Accounting Method is the model originally envisaged by the early drafts of the MIFID II guidance. This approach was pioneered by Scandinavian asset managers and is often referred to as the “the Swedish Model”. To avoid any confusion, I will refer to this approach as the Accounting Method going forward.
The Accounting Method relies upon the asset manager agreeing a specific research charge with each of their clients. The requirement to obtain clear agreement with each client is greater in this approach, relative to the Transactional Method, because the Accounting Method introduces a new way of collecting the charge i.e. by withdrawing it directly from client funds. The asset manager would then trade with every executing broker at an execution-only rate.
This approach is called the Accounting Method because the asset manager calculates a daily proportionate accrual of the annual research charge agreed with its clients. The accrued charge is then physically withdrawn from each fund on a monthly or quarterly basis (largely dependent on the frequency with which it makes payments to its research providers). The research charge would then be sent to one or more RPA administrators who would manage all payments for research on their behalf. Every research provider would therefore receive a cheque for their research service, totally independently of their trading activity.
Irrespective of which funding method is used, we believe that any of the following may administer RPAs in the future for asset managers:
- an independent third party administrator
- a fund accountant or custodian
- A broker
- The asset manager’s own accounts payable team
Why use the Accounting Method to fund a RPA?
There are a number of benefits to using the Accounting Method for funding a RPA
Challenges with using the Accounting Method to fund a RPA
The table below describes a number of challenges with using the Accounting Method to fund an RPA.
The P&L Method
There have been a number of asset managers who have recently decided to pay for research themselves, out of their own resources i.e. on a hard dollar basis. There are a number of benefits to paying for research out of a firms own resources:
Challenges with using the P&L Method to fund research expenditure
The table below describes a number of challenges with paying for research out of a firms own resources:
We believe there may be a few reasons why a firm decides to pay for research themselves:
- They believe it’s too difficult to meet the new regulatory reporting requirements imposed by MIFID II. (In our opinion, such fears are unfounded);
- They have a large internal research team whose investment process has little reliance on external research;
- They have a small research budget that would have little impact on their bottom line if paid for themselves;
- They can increase their management fee to offset the cost of research;
- They have seen other firms taking this approach and believe they would not be able to compete if they didn’t follow suit; or
- They feel it’s their duty as an asset manager to pay for research costs themselves rather than pass on these costs to their clients.
Ultimately each firm may make this decision based on a cost/benefit analysis. If the cost of paying for research themselves is not much greater than the cost of buying or building a regulatory compliant solution, then it seems obvious that the firm is likely to make the decision to pay for research out of their own resources. However the decision doesn’t seem as clear cut for firms with a research budget of greater than $1m. Any such firm who makes a decision to pay for research out of their own resources will most likely do so for one of the reasons specified above.
There isn’t a single answer to the question “How should I pay for research”? It seems that each firm is going to make a high level decision on whether they will pay for research themselves out of their own P&L or whether they are going to continue using their client funds to pay for such costs. If they choose to use their client funds (and are based in Europe), then they will have to use a RPA once MIFID II goes live. The pros and cons of the two methods for funding a RPA described above may hopefully help firms in deciding on the approach that best suits their firm, their clients and their investment process.
It should be noted that solving the funding problem alone doesn’t make it possible to use an RPA. Firms additionally have to prove that they are using their clients’ funds wisely by regularly assessing the quality of research they have consumed. They also have to be able to report to their client (and the regulator) exactly where their money has been spent.
I have no doubt that there will be other pros and cons that have not been included against the various funding options considered in this article. I welcome your feedback on any such omissions and invite you to join our LinkedIn Group called “Research Payment Accounts” which can be found here to continue the discussion.
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