FCA Consultation Paper CP 24/7 – Payment Optionality for Investment Research
In this article, we outline the background and context of these proposals and discuss what it means for firms and the asset management industry from both a UK and global perspective.
Introduction
This is the first substantive action taken by the FCA in response to the Investment Research Review, one of the Edinburgh Reforms and the UK Wholesale Markets Review. This independent review examined investment research and its contribution to UK markets competitiveness, forming part of changes underway to enhance the UK’s ability to attract companies to list and to grow.
The UK Investment Research Review was carried out by Rachel Kent and was published on 10 July 2023. In the report, Rachel Kent made seven recommendations to protect and develop the UK as a centre of excellence for investment research, including:
- To allow additional optionality for paying for investment research
- To clarify the UK regime for investment research, including simplification and/or clarification of the requirements of the FCA’s rules applicable to providers and users of investment research and including a bespoke regime relating specifically to investment research
- To allow greater access to investment research for retail investors.
This consultation paper is the FCA’s proposed response to the first recommendation; that of offering FCA asset managers greater optionality for paying for investment research. The FCA is proposing to make the changes apply consistently across investment firms and collective portfolio managers and is an example of the simplification of the rules on research in recommendation 2 above.
The FCA is not, however, proposing to apply these changes at this stage to UCITS management companies, full-scope Alternative Investment Fund Managers (AIFMS), small authorised UK AIFMS or residual Collective Investment Scheme Operators; therefore creating an even greater divergence, albeit temporarily, between investment firms and the rules in COBS 18 governing UCITS ManCos, AIFMS and Residual Collective Investment Scheme Operators.
Rather than introducing a uniform regime for all buy side firms at this stage, the FCA is instead planning for a further consultation later this year. This raises the question of how seriously the FCA is taking its commitment in Chapter 3 of its Discussion Paper, DP23/2: Updating and improving the UK regime for asset management to restructure the asset management regulation regime in order to set clear and coherent requirements for firms. Interestingly, the FCA’s proposal to not set clear and coherent rules across the asset management industry at this stage was disclosed within the ‘Who this applies to’ section of the Consultation Paper CP24/7 and so therefore does not invite feedback on this approach. UCITS ManCos, AIFMS and Residual Collective Investment Scheme Operators may wish to provide feedback on this point.
Background
In the UK, bundled investment research was a value add created by UK brokers during a time of fixed commissions as a way of differentiating brokers service offering. With deregulation and the abolition of fixed commissions, the practice of brokers bundling research with commissions continued, but came under scrutiny by the UK regulator, the FSA, in the early 2000s. The first action was taken by the FCA CP13/17: Use of dealing commission which came into force in June 2014 in anticipation of the wholesale changes to the market for investment research to be brought in by MiFID II in January 2018.
Under the unbundling rules in MiFID II, asset managers must either:
- Pay for research out of their own resources; or
- Put in place, what it referred to as, a Research Payment Account (RPA) where the asset manager agrees a separate research charge with each of its clients.
RPAs are seen as ‘operationally complex and resource intensive’, complicated to administer and costly. They are also unattractive for asset managers in a market where many of the larger firms opted to move to paying for investment research out of their own resources. Take up of RPAs has therefore been low, with the great majority of asset managers choosing to pay for investment research out of P&L; an outcome that suited larger firms with deeper financial reserves and left the smaller firms having to use RPAs with their administrative complications and costs. In this way it operated as a barrier to competition and the FCA states in this consultation paper that one of the benefits of its proposals is that smaller firms, especially new entrants or fast growing firms, will have the opportunity to utilise an option more in line with their business growth, one that is less complex and less resource intensive than the RPA.
Following the changes introduced by MiFID II there was a reduction in spending on investment research by asset managers, which the FCA sees as an indication of asset managers being more careful with their own money than they had been with the consumption of investment research when it was being paid for by clients through brokerage commissions. A win by the regulator indicating that “the new rules have steered the market towards the intended outcomes.1”
The market for investment research since MiFID II
The reduction in research spend partly reflected a decline in investment research coverage that is felt to have a number of causes, not simply a result of MiFID II’s unbundling requirements. The FCA provides evidence in its consultation paper supporting its conclusions that:
- independent research providers do not seem to have been disproportionately impacted and indeed may have benefited from it to some bundling provisions
- there were no countries, geographical regions, sectors or capitalisation strata in which UK asset managers were unable to secure adequate research the majority of firms did not consider that MiFID II had impacted either the quality or quantity of research available to them; though 14% of firms said that it did
- most firms did not think MiFID II had impacted their ability to purchase research from overseas, nor had the expiry of the 26 October 2017 SEC No Action Letter had any material impact on their ability to access the research they needed and that it may have driven operational efficiency
- overall, there is little evidence of negative impact arising from MiFID II on the international competitiveness and growth of UK equity markets and listed companies
- the decline in research spend in the UK from the introduction of MiFID II to the present of circa 30%-40% reflects similar declines in research spend in major non-MiFID jurisdictions, indicating that the decline was not due to MiFID II, with the FCA noting that this decline in research spend had largely flattened out by 2023.
For these reasons the FCA does not agree with the views recorded in Lord Hill’s UK Listing Review of 3 March 2021, which noted that “Comments supported the view that the post MiFID-II environment has been detrimental to both the quantity and quality of SME research.”
The FCA also commented that the decline in research spend may in part reflect that some asset managers had invested in growing their in-house research capabilities as a substitute for external research. The FCA does, however, recognise Rachel Kent’s point that “paying for investment research from own resource is maybe less sustainable, as it is susceptible to spending cuts during a market downturn (when fee income on assets under management declines), is less responsive to changes in demand (e.g. meeting ESG requirements or reallocating capital to domestic small cap companies) and is less likely to foster speculative and innovative research (e.g. in niche and growth sectors)”. These are precisely the sectors that HMT wishes to encourage and was one of the purposes behind the Investment Research Review.
The FCA’s proposals are an example of HMT’s Smarter Regulatory Framework for financial services. The Treasury is building a smarter financial services framework for the UK.
The proposal
The proposal is to allow for an additional option to pay for investment research that will sit alongside the current options of paying for research out of P&L or through the use of RPAs. This option is to allow “joint payments for research and execution services” (“Joint Payments”), subject to what the FCA described as appropriate ‘guardrails’ to protect investors.
The appropriate guardrails
1. Formal policy
The firm must have a formal policy describing its approach to Joint Payments and how the firm will ensure compliance with the guardrails that are contained within the new COBS rules in COBS 2.3B.25 R – COBS 2.3B.31 R.
2. Written agreement
The firm must have written agreements with research and execution service providers which establish a methodology for how research costs will be calculated and identified separately within total charges for Joint Payments for third-party research and execution services.
3. Research provider payment allocation structure
The firm must have a research provider payment allocation structure for the allocation of payments between different research providers, including:
- third-party research and execution services
- independent research providers not engaged in execution services.
4. Payment account management
The firm is responsible for administering the accounts for purchasing research from Joint Payments and ensuring the operation of these accounts is in compliance with the firm’s obligations under COBS and ensuring the timely payment to research providers.
5. Budget
The firm must set a budget, at least annually, for the purchase of research using Joint Payments that:
- is based on the expected amount needed for third-party research in respect of the investment services rendered to its clients and is not linked to the expected volumes or values of transactions executed on behalf of clients
- is applied at an appropriately aggregated level (e.g. for similar investment strategies or groups of clients who would benefit from the same research).
6. Fair allocation
The firm must allocate costs of research purchased using Joint Payments fairly between clients. This should determine a cost allocation level that is appropriate to the business model. It is not necessarily that the specific cost of individual pieces of investment research be discretely attributable to individual clients. The approach must be reasonable and its outcome fair across all clients, in order that the relative costs incurred are commensurate with the relative benefits received. This includes across:
- clients with which the firm has different payment arrangements for the purchase of research
- clients that are managed according to similar investment strategies
- different clients or groups of clients that benefit from the same research.
7. Disclosure
The firm must disclose to relevant clients:
- the firm’s use of Joint Payments for research including, where relevant, how the use of Joint Payments is combined with payments out of the firm’s resources or payments out of RPAs
- the key features of the firm’s policy on Joint Payments for third-party research and execution services, or the policy itself, with regards to the information needs of the client and ensuring communication in a way that is clear, fair and not misleading
- the expected annual cost to the client provided as part of ex ante disclosures on costs and charges and based on both:
- the budget setting and cost allocation procedures
- the actual costs for prior years
- the most significant research providers measured by total amount paid and the benefits and services received from such providers at an appropriate level of aggregation relevant to the client; such as for similar investment strategies or groups of clients who benefit from the same research
- as part of the annual ex-post reporting on costs and charges, the total costs incurred by the client disclosed on an annual basis reflecting the total payments for research purchased using Joint Payments over the period
- if relevant, the amount by which the research charges exceeded the budget.
Measuring success
The FCA commits to measuring the success of the rules that are made through firm surveys and multi-firm supervisory work, with a focus on those areas that the Treasury has identified as being harmed by the current regime; specifically, research on UK SMEs and research by smaller firms and independent research providers. The FCA expects that the benefits from the changes may only be seen over the medium term.
The Consumer Duty and Treating Customers Fairly
The FCA notes that a firm’s obligations under PRIN 12 and PRIN 2A mean that it must ensure that its policies and operational arrangements for bundled payments for third-party research and execution services provide an appropriate level of protection for retail customers. This warning implies that compliance with the new Joint Payment rules is not sufficient for firms within the scope of the consumer duty, bringing uncertainty for some firms over the extent to which they can take advantage of the new payment optionality. For those firms falling within its scope, it may have been clearer had the FCA indicated that a breach of the new requirements would also be a breach of consumer duty rules.
The FCA makes a valid point that there is a risk of both consumer harm and conflict of interest arising from cross subsidisation of research costs between different clients or across different investment strategies and there must therefore be a fair allocation of costs among clients, whether retail or professional, on the same payment option. This point echoes the FSA’s concerns in its 2012 report, “FSA Report, Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks.”
The global perspective
The FCA accepts that both currently available options for the payment of investment research could have negative effects on UK asset managers’ ability to purchase investment research across multiple jurisdictions, therefore impeding their ability to compete effectively on a global basis. It highlights the imbalance between the UK MiFID II derived unbundling regime and the prevalent use of soft commission arrangements in the US. The FCA has formulated the new Joint Payment option in order to facilitate accessing research globally, giving UK asset managers the ability to compete on an international scale. In this way, the FCA’s proposals are designed to comply with the secondary objective introduced by FSMA 23 of facilitating the international competitiveness of the UK economy and its medium to long term growth; subject to aligning with relevant international standards.
The FCA also refers to the fact that the EU is in the process of making its own changes to the MiFID II unbundling regime. What it does not mention, and might the profitably have done so, is that due to rule-making process in the EU, such changes will take considerably longer to implement than the FCA’s changes. This is one of the benefits of FSMA 2023, giving the FCA the power to make firm-facing rules more swiftly than its EU counterparts.
Short-term trading commentary
Whether firms pay for research from their own resources, use RPAs or use the new Joint Payments option, the FCA is making changes to the rules in COBS. 3A.19R (5) to make commentary and advice linked to trade execution an acceptable minor nor monetary benefit for all payment options. This will enable firms to receive research that is in the form of short-term trading commentary from US broker dealers on a bundled basis.
Timetable
The UK Investment Research Review was issued on 10 July 2023 and on the same day, the Treasury and the FCA welcomed the report and committed to make relevant rules by the first half of 2024. As a result, there is now a short, eight-week consultation period and firms have until 5 June 2024 to provide their comments on these proposals. It is likely that these rules will be in place by 30 June 2024; an example of the Smarter Regulatory Framework in action, with the FCA using its newly-bestowed powers for swifter rule making.
Contact us
If you would like to discuss any of the issues raised in this article, please contact your usual Waystone representative or reach out to us via the below.
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