Bundled Research Payments – Is It Really New, or Just Déjà Vu?

In a not wholly unexpected move the FCA published Consultation Paper CP 24/7 on 10th April introducing “payment optionality” for investment research.

Background

Research, and the payment for it, was the subject of an overhaul when the obligations for MIFID II came into effect in January 2018 requiring firms to pay for their consumption explicitly through their own resources (the PnL model) or via a research payment account (RPA). Further tweaks took place in 2021 with adjustments to what was considered a minor non-monetary benefit and how rules apply to independent research. Then came the Edinburgh Reforms and the announcement of an Independent Research Review, led by Rachel Kent, the Economic Secretary to the Treasury, with the outcomes being published in July 2023.

It is widely acknowledged that the MiFID II unbundling requirements have not achieved all of the anticipated benefits that were hoped for. For example, there hasn’t necessarily been the total price transparency, nor has it led to more availability or different sources for research. The RPA is also considered unnecessarily complex (and this is now being acknowledged by the FCA); the demands are disproportionate on smaller firms, who arguably should be using it more than larger businesses as they have less ability to absorb costs into their own resources. Therefore, many investment managers use the PnL method. According to the Independent Research Review, this has had a potentially negative impact on economic growth as some research capabilities have been brought ‘in house’ and less has been produced, which has had a negative effect in UK capital market depth and funding for UK companies. Rachel Kent also expressed concern in her report that the PnL model has the potential to be unsustainable or subject to possible reductions in the event of a market downturn and highlights the contrast between the UK and U.S. approaches.

Additional optionality

To address these matters, the FCA’s CP24/7 Review made seven recommendations, in which the FCA added optionality regarding payment for research. It proposed firms retain the RPA and PnL methods, but the FCA proposes to also permit asset managers to pay for research on a bundled basis.

This is particularly interesting given the FCA’s stance during the MiFID II consultation process. The regulator was extremely vocal and a strong supporter of removing the bundled payment arrangements, which were commonplace before January 2018. The FCA’s concern back then was that bundling payments led to less disciplined spending on research – meaning duplicative or low quality research was seeping in, together with inappropriate influence on execution decisions and potentially opaque charging structures. It is keen to ensure that these ‘harms’ do not re-emerge with the (re-)introduction of bundling.

In order to control bundled payments for research, the FCA is consulting on what it is calling “appropriate guardrails” to protect investors. These requirements include obligations to implement:

• A formal policy outlining the firm’s approach to payments, governance, and decision making and how these are separate from execution arrangements
• Budget for third-party research spent, renewed at least annually and based on expected amounts needed to purchase research as opposed to being tied to volumes or values of transaction, with the intention this avoids duplication and low quality research consumption
• Periodic assessment of price and value of research and how it adds to investment decision making, performed at least annually
• Cost allocation procedures for both clients and research providers designed to promote transparency and price discovery
• Operational procedures for account administration, including reconciliation and reporting requirements and timely payments to research providers
• Client disclosures that include details on the approach adopted by the firm, and how the requirements are met together with the costs associated with the firm’s most significant research providers

Whilst there appears to be some overlap with the requirements for operating an RPA, the FCA hopes that this ‘new’ option will be less operationally burdensome and less resource intensive for firms. It may also appeal more to new market entrants as it would involve far less in the way of set-up costs, and therefore they would not be disproportionately constrained by the availability of their resources.

Competition objectives

It’s very apparent through the CP that global competition is also appearing top of mind for the FCA with these proposed changes. Firstly, compatibility with the U.S. regime is (currently) limited given the commonplace use of ‘soft dollars after the expiry of the no-action letters. By introducing this third payment option, UK asset managers will be able to obtain research from global sources without impediment, remaining globally competitive. Similarly, the EU is also introducing flexibility for EU asset managers when paying for research, re-announcing bundling with their own version of “guardrails” – only some of which overlap with the UK’s proposals. It is hoped that these new measures will ultimately advance competition without creating undue harm and is worth noting that despite the origins of the rules being added to were in MiFID II, the FCA did and will continue to extend the remit of the requirements, including this new optionality to AIFMs.

How will the market respond?

One further point to consider here however, is that despite what the regulator ultimately decides to do with the rulemaking, is the market’s response.

Investment managers might likely welcome the additional optionality however there remains an open question as to whether investors or asset owners themselves will actually tolerate a ‘wind back’ should a firm elect to adjust their research payment models. There is an argument here that those groups have actually become used to transparency and the way their money is being spent, so will they accept that change?

Will investment managers want to engage in those possibly uncomfortable conversations with their clients, or counterparties, about research payments? Many asserted to the FCA that they had done a lot to adapt to the MiFID II requirements, so there may be a general reluctance to reverse this. Given more is known now about low execution costs, will the buy-side want their counterparties to conflate prices once more?

Also, how will the sell-side react? It has become used to pricing the execution and research components separately. It is not a mandatory requirement that they facilitate payments on a bundled basis, nor can they require a buy-side firm use the bundled arrangements.

Only time will tell…

Conclusion

The FCA CP is open for comment until 5th June 2024, and the timetable for final rules will be dependent on the amount, strength and breadth of industry feedback received. Industry participants are encouraged to respond and stay abreast of how the FCA intends to deal with the other six recommendations arising from the Independent Research Review.

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