The Financial Conduct Authority ("FCA") has published a Discussion Paper (DP14/3) "Discussion on the use of dealing commission regime: Feedback on our thematic supervisory review and policy debate on the market for research."
Investment managers will be aware that the FCA has been holding discussions with the industry and conducting a thematic supervisory review (between November 2013 – February 2014) as to the controls that investment managers have over the use of dealing commissions for the purchase of research. The Discussion Paper reports on the FCA's supervisory findings. The FCA considers that many firms do not apply a sufficient level of control and oversight on research spending from dealing commission and need to improve their controls. The FCA recently set out revised rules and amended guidance in its policy statement on Changes to the use of dealing commission rules (PS14/7) which came into effect on 2 June 2014. Please see our briefing on this.
Overall they conclude that unbundling research from dealing commission would be the most effective way to manage any conflicts of interest that arise where brokerage costs fund external research.
The DP looks more broadly at whether structured reform is needed to ensure investment managers are managing costs appropriately in the best interests of their customers and the competition implications of that. Their objective is to ensure value for money is achieved by investment managers for their underlying investors. This review on the use of dealing commissions forms part of the FCA's review of wholesale conduct issues. The FCA also looks at this issue in its paper published in July 2014 'wholesale sector competition review – call for inputs'. This builds on the regulators focus on investment managers and their conflicts of interest management including their controls on spending on research and execution services which has been a continuing theme for some years.
The DP discusses the potential reforms under MIFID II and the direction of those reforms. This will be of interest to brokers, providers of independent research, customers of investment managers and investment managers including UCITS management companies and AIFMs.
As the DP is wide ranging, this briefing focuses on the findings from the thematic work and the steps that the FCA believes firms should take to ensure their existing practices and systems and controls meet the FCA's current rules on the use of dealing commission.
2. Supervisory Findings
The FCA reviewed 30 firms as part of it thematic review involving 17 investment managers and 13 brokers, as well as speaking to independent research firms and corporate issuers.
Of the firms reviewed the FCA found that whilst some firms had improved their governance over how they purchase research with dealing commissions, only a few were applying sufficient rigour in assessing the value of the research services received. Only two firms were operating at the level the FCA would expect.
The FCA recognises that there is a lack of price transparency for research and the DP explores a range of models adopted by brokers for assigning costs and assessing the profitability of their research offerings. Nevertheless the FCA clearly believes firms should be taking action now to improve their processes.
3. Purchase of research
We set out below indicators of good and bad practice found by the FCA.
Click here to view table.
The FCA suggests that the following features identified amongst the controls used by investment managers, when used in combination, provide a "fairly robust set of controls over the amounts spent through dealing commissions on research, and, to some extent, place a value on specific research goods and services received".
- Separate internal governance and decision making processes to assess research needs and identifying which providers can provide the services at the best price and making that as a separate decision from the decision over where to direct trades
- Setting a research budget not influenced by trading volumes and managing this by the use of CSAs, and by moving to execution rates (rather than bundled rates) with a broker once any research cap has been reached
- Not rewarding research that doesn't add value even if supplied
- Seeking a specific price for research as far as possible
- Broker voting processes which ascribe a clear monetary value to each vote.
Firms should therefore consider undertaking a gap analysis which would benchmark their existing controls against those listed below and take appropriate steps to introduce the necessary tools to address any weaknesses identified.
4. Transparency and disclosure of costs and best execution
The FCA commented that it does not consider that better disclosure to customers would necessarily be sufficient to mitigate any conflicts arising from the use of dealing commission to acquire external research. Firms should still be applying the same degree of rigour in spending dealing commission as a firm would apply to spending its own money.
The FCA questions how firms can comply with rules on best execution if it is not clear from bundled commission rates what the execution costs are i.e. the execution component may not reflect the cost and value of the execution service in the same way as research commissions may not reflect the value of actual research received.
5. MIFID II Inducements rules for portfolio managers
The level 1 text of MIFID II prevents portfolio managers from receiving any third party inducements, with a limited exception for minor non-monetary benefits. The ESMA consultation paper which proposes advice to the European Commission on the detailed rules which will implement MIFID II discusses the meaning of 'minor non-monetary benefits'. ESMA considers that this should be narrowly construed so that only very generic, widely distributed financial research will be considered as a minor non-monetary benefit.
If this interpretation is adopted, the FCA believes this would require the unbundling of most research from dealing commission arrangements. This would require significant changes to COBS 11.6.
ESMA has recommended that the changes proposed under MiFID II should be harmonised across UCITS and AIFMD to apply to UCITS management companies and AIFMs so that inducement standards are aligned across all areas of investment activity. The FCA supports this.
In addition it should be noted that the inducements rule in MiFID II applies to research in respect of all financial instruments and not just to equity research to which the current COBS 11.6 applies.
6. What is next?
The FCA wants firms to consider their current controls surrounding use of dealing commissions and take steps to ensure their existing practices, systems and controls meet the FCA's current rules. Firms may find it useful to take account of the supervisory findings in considering steps they could take.
Firms will probably already be reviewing trade associations responses to the ESMA consultation paper but may also want to respond to the FCA's comments on the impact of unbundling research from execution arrangements.
The FCA expects to provide further feedback once it has had an opportunity to review the development of MIFID II following ESMA's consultation. This is expected towards the end of 2014 or early 2015. It is clear from the industry's response to the consultation that investment managers do not consider that research should be treated as an inducemnt but should be acceptable as a minor non-monetary benefit.
The FCA has said it will not make any further changes to its rules in this area pending implementation of MIFID II.
The FCA acknowledges that any change in the rules may have competitive implications for firms which are part of wider international firms and accordingly proposes to engage with other international regulators on these issues through IOSCO.