UK/EU Commission Equity Commission "Re-Bundling" Proposals
In December, 2022 both the UK and the EU announced potentially significant changes to research regulation stemming from MiFID II. Both jurisdictions sought to liberalize the MiFID II research payment regime.
In the UK, the Chancellor announced The Edinburgh Reforms, a wide-ranging review of thousands of pages of EU Financial Services regulation that would have to be altered in light of Brexit.
Part of this was the MiFID II Research Review. In the announcement the Chancellor specifically referred to " MiFID II commission unbundling" and noted that the UK and the US were not operating on a similar rule set. (This was consistent with the Competition remit which he had simultaneously given to both the FCA and PRA).
The MiFID II Research Review was chaired by Rachel Kent. It was tasked with delivering a report to the UK Treasury with ideas on how to stimulate research production and access to enhance the global competitiveness of the UK capital market by June 30th, 2023.
The report was delivered on schedule and its recommendations were immediately accepted by the Chancellor.
Its key recommendation on research funding was that managers should be allowed to re-bundle research payments (using client money for research) by informing the asset owner of the research charge. This differed from the MiFID II requirement to obtain client consent for research spending.
A related but key recommendation is that manager charging asset owners for research should benchmark research spending. Critically, this is not benchmarking how much a manager pays for firm-wide research document access or an hour of a sell-side analyst's time. This relates to how the manager's fund-level research spending compares to similar strategies. (Asset owners don't care how much managers pay individual research providers). What they do care about is that the manager's fund/strategy spending is proportionate and competitive. Frost Strategy Research Benchmarks are specifically designed for this environment. https://researchspend.frostconsulting.co.uk/
The UK MiFID II Research Review recommendations will remove a key impediment to managers returning to using client money for research (as 99% of US managers do), thus potentially levelling the playing field.
The quid pro quo is that it will require managers to provide fund-level research transparency, which most have not done. (Frost has a suite of products specifically designed to do this, including Equity Strategy Research Spend Benchmarking.
The FCA has stated that it anticipates new rules being in place by 1H 2024. Given planning timeframes, UK asset managers should be examining their research policy options immediately. Other considerations may include the fact that the market could shift quite quickly, as it did in the run up to MiFID II implementation in the fall of 2017.
Research and ESG funding are important factors in manager profitability, alpha generation and investment staff retention.
Frost has specialist platforms that have successfully helped manager demonstrate the fund-level research transparency that has allowed them to transition back to client money for research. www.frostrb.com
The EU
Also in December 2022, the European Commission altered the EU Capital Markets Recovery Package with a proposal to raise the 1 Billion Euro small cap. MiFID II research waiver to 10 Billion Euros. As the graphs below illustrate, these would cover ~80% of the stocks in MSCI Europe (by number).
Raising the market cap. limit for MiFID II research exemptions to 10 billion Euros transforms the proposal from a minor afterthought for small/micro-cap funds to a mainstream consideration for even large asset managers/ owners. This is because it significantly expands the percentage of stocks potentially included in major equity indices that form the benchmark for thousands of funds and separate account /institutional mandates worldwide as the chart below illustrates.
The blue bars represent the percentage of stocks in various indices that would have been subject to the MiFID II research exemptions under the 1 Billion Euro limit. The green bars represent the percentage of stocks included under the 10 Billion Euro limit.
The net result is that a majority of stocks in many important indices are included under the higher limit, thus changing the competitive calculus for even large cap. (and large AUM) managers.
Outcomes
More recent EU proposals have suggested dispensing with the 10 Billion Euro market cap. limit, giving EU managers the potential ability to re-bundle at will as long as they informed the asset owner of the research and execution charges on a per fund basis - similar to the UK proposal.
There is no doubt that EU actions will be influenced by the regulatory evolution in the UK as both the UK and EU seek to maintain globally competitive asset management industries. This altered regulation is also in recognition of the fact that US research funding rules are unlikely to change, regardless of which party is in power.
Like their UK peers, EU managers now face a choice of whether they want to take advantage of the greater flexibility potentially offered by this regulatory change.
Frost Analysis Models
Frost Consulting has proprietary quantitative techniques that can be customized to allow asset managers to better understand the profitability and research access impacts of moving back to funding research/ESG via client money.