Banks Seek Easing of ‘Draconian’ EU Equity Research PlanJim Brunsden, John Detrixhe and Ben Moshinsky
Investment banks want the European Union to scale back potentially “draconian” draft rules that would rein in asset managers using clients’ money to pay for equities research.
The European Commission, the EU’s executive arm, is weighing how far to go in forcing asset managers to separate payments for research from those they make to banks and other brokers to execute trades. These costs are commonly lumped together, a practice known as bundling.
While the U.K.’s Financial Conduct Authority says that an unbundled system could enhance competition and transparency, banks and asset managers have argued the change would put EU-based fund managers at a disadvantage to overseas rivals and prompt them to cut back on research that supports investment.
While “ambiguities” in the draft rules make it difficult to assess their impact at this stage, “depending on how they are implemented, they could be draconian,” Christian Krohn, head of equities at the Association for Financial Markets in Europe, said in an interview. “We’re concerned that there are unworkable conditions attached to paying for research using client resources.”
The commission plans to publish rules by mid-year as part of its work to overhaul EU financial-market legislation. The bloc’s 28 national governments and the European Parliament will have six months to raise objections. If they don’t, the final standards could be issued by year-end and take effect in 2017.
‘Conflict of Interest’
According to FCA data, U.K. investment managers alone pay about 3 billion pounds ($4.6 billion) of commissions per year to brokers, with about half spent on research. The system contains an “inherent conflict of interest” because it means asset managers buy research using their clients’ money rather than their own, the FCA says.
“We believe ESMA’s proposal will lead to direct accountability over the expenditure on third-party research by portfolio managers and how these costs are passed to their customers, leading to better outcomes for investors across the EU,” the FCA said Feb. 19 in a statement.
The FCA had 46 respondents to a report seeking views on the dealing-commission proposal, including investment managers, research providers and brokers. Some said the rules were unnecessary and would make it less attractive to research small companies, potentially limiting their access to capital.
“There were respondents who disagreed that the existing regime needed further reform,” the FCA said. “They viewed investment managers would only buy research and incur costs if it was in their client’s best interests, and that there was no real conflict of interest in current dealing-commission arrangements.”
The European Securities and Markets Authority, which brings together national regulators in the EU, provided guidance to the EU commission in December that retreated from earlier proposals requiring a full separation of payments.
Under ESMA’s approach, the model of using client money to pay for research would still be allowed to exist within a series of rules. Investment managers would have to set up dedicated “research payment accounts” funded by a specific charge to the customer and agreed on in advance.
An investment management firm would only be able to increase its research budget with its client’s written consent. Also, the size of the research charge couldn’t be linked to the volume or value of transactions executed on behalf of clients.
“The people it’ll hurt most are the investment banks,” Neil Robson, a financial regulation lawyer at Katten Muchin Rosenman in London, said in an interview.
“They’re going to have to put a value on what they think that research is worth,” Robson said. “As an investment manager you’ll have to decide at the beginning of the year how much you want to spend on research, and then you’ll still have to justify that there’s some benefit from it, some original thought that’s going to give you value.”
AFME, which represents international lenders including Deutsche Bank AG, BNP Paribas SA, HSBC Holdings Plc and Royal Bank of Scotland Group Plc, is concerned that the rules on written consent could be difficult to apply in practice.
Krohn said that an “overly expansive interpretation” of the restrictions on linking charges to the volume and value of trades could also mean the end of commission-sharing agreements.
Such agreements are used by brokers and asset managers to address conflicts of interest in how research is paid for by making it easier for managers to divert money toward other research providers.
Banks warn that the risk is that ESMA’s restrictions could leave the financial-services industry with little choice but to shift to a fully unbundled, so-called “hard-dollar” system, in which fund managers make business decisions on the research they want to buy and pay for it themselves, separately from other activities.
Such a shift “should happen worldwide to avoid the detrimental effects that arise from differences in competitiveness of investment managers,” AFME’s Krohn said. “Still, it’s hard to see who would benefit.”
While part of the discussion of the rules has focused on the equity market, financial firms have also raised concerns that the measures could force changes in the financing of research for the fixed-income market as well.
Requiring brokers to split research and trading fees should result in narrower credit spreads for fixed income investors, the FCA said.
Applying the EU proposals to fixed income markets “will bring transparency in an area that is currently more opaque than equity markets since research is entirely embedded in implicit transaction costs,” according to the FCA.