Last month’s SEC decision to allow its MiFID II research no-action letter to lapse could damage relationships between European/global asset managers and US brokers, potentially disrupting the investment research market, according to a report by Substantive Research, which operates a research analysis and delivery platform.
The SEC’s no-action letter – now set to expire in a year’s time – was originally designed to address the discrepancy in investment research delivery models introduced by MiFID II in 2018. The far-reaching EU regulation required European asset managers to pay for investment research in cash, ending the soft-commission model that had operated for decades. US rules, however, continue to require asset managers to pay for research through trading commissions, and so the no-action letter was devised as a temporary measure to allow MiFID II-regulated entities to pay US brokers in cash.
Last month the SEC announced that it “does not intend to extend the temporary position beyond its current expiration date in July 2023.” This means that European asset managers will no longer be allowed to pay for US broker research in cash, and instead must pay through trading commissions, as their US counterparts do. Firms affected by the decision now need to implement changes to their investment research arrangements to comply.
Substantive Research CEO Mike Carrodus says, “The fact that this has come out without warning, and so quietly, may indicate that the SEC expects asset managers and brokers to be able to adapt to these changes without too much disruption. But our latest industry survey makes it clear that this will create enormous problems for both asset managers in Europe and the many US brokers that provide them with investment research.”
According to Substantive’s survey of 40 investment managers – 85% European, 15% global/US – however, many market practitioners fear they may not be able to implement the required changes in time. A 60% majority of survey respondents said the most likely outcome is that global US brokers will be paid entirely in Europe for research consumed in both regions, potentially putting $100 million of annual research payments at risk. Of those survey respondents, 68% believe that this change will mean market share further consolidates to the bulge bracket firms, decreasing competition in the research market, which has already been hit by MiFID II’s deflationary effects on research pricing.
Views are split on possible solutions. In particular, survey respondents question whether brokers becoming Registered Investment Advisors (RIAs) solves research payment challenges, while Research Payment Accounts (RPAs) for the buy side were not considered a desirable option. Either way, respondents suggest they cannot be implemented in time.
So far, six brokers, among them BAML and Jefferies, have become RIAs, which allows them to take research payments directly and in cash. Other brokers have decided against it mainly due to the added compliance burden and survey respondents expressed still strong reservations. Even if they did decide to go ahead, the research suggests that it this solution would not allow them to supply the usual sales and trading content through the RIA, and they may have to create dual entities to provide the full research relationship to clients. The survey was inconclusive on whether large US brokers who haven’t yet registered as investment advisors will now do so.
An alternative approach would be for European asset managers to create RPAs, which would allow them to generate research payments from trading commissions under MiFID II. However, these come with a complex administrative burden in order to comply with existing research unbundling rules, and there may be further regulatory clarification required for it to work. For that reason, 100% of survey respondents had a preference against implementing new structures internally in order to pay US brokers who don’t create new entities or become RIAs.
Finally, survey participants suggested that the SEC could introduce an ‘RIA-lite’ designation that would be less onerous for brokers. This would probably reduce the timeframe needed to register, and would remove key obstacles that the brokers’ compliance departments have identified. This approach was suggested in 2017 but the no-action relief obviated the need to proceed with it at the time.
Carrodus added: “While this was not a problem of their own making, by far the simplest solution is for the SEC to listen to feedback from the US brokers and global asset managers headquartered in the US, and extend the No-Action for at least another year. RIA and RPA solutions cannot be put in place by July next year, even if brokers and asset managers started working on them now.”
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