Fund Managers Warn on Esma Research Proposals 

Terry Flanagan

Fund managers and Sifma have warned that the proposal from European regulators to impose restrictions on using dealing commissions to pay for research will harm investors and put the region at a competitive disadvantage.

The revised Markets in Financial Instruments Directive, which covers trading in the European Union, said that from January 2017 research cannot be distributed for free and costs must be unbundled, or separately identified, unless certain conditions are met. The European Securities and Markets Authority published responses to its consultation on MiFID II on its website for firms that chose to make them public.

AllianceBernstein, the asset management subsidiary of French insurer Axa, wrote that it disagreed with Esma. The response said: “We consider these proposals are not in the best interests of our clients and believe the changes are likely to have unintended adverse consequences for EU financial markets.”

The fund manager argued the proposal will lead to a decrease in the availability and quality of sell-side research, particularly for smaller companies. The buy-side will need to replace this lost coverage internally which will lead to higher costs and ultimately higher fees for investors.

AllianceBernstein said: “We understand that the prospects for a global solution are remote, particularly given that the present arrangements are enshrined in statute in the US, but implementation of Esma’s proposals on anything but a global basis would create serious distortions in the asset management market.”

The asset manager suggested that the use of  commissions to pay for research should be regulated as the management of a conflict of interest – the use of Commission Sharing Agreements should be enhanced, there should be improved governance over the setting, allocation and oversight of research budgets and fully transparent disclosure to investors of the total amount of dealing  commission paid, the amount used for research, and the research services received.

Blackrock, the largest global fund manager, agreed that the payment for research should be framed primarily as a conflict of interest and suggested similar solutions to AllianceBernstein.

Blackrock said: “We are not aware of evidence having been uncovered that research “induces” portfolio managers to trade (or to trade with certain brokers at the cost of poor execution quality), or to “churn” or (in commission-based markets) to agree higher execution rates.”

US manager Vanguard wrote that as a result of its primarily passive fund management strategies in Europe, it was unlikely to be significantly impacted by Esma’s proposal.

Vanguard said: “Nevertheless, we are of the view that Esma’s proposal to classify investment research as a non-monetary benefit under MiFID II could have unforeseen consequences and possibly cause major disruption to well-established and well-functioning relationships to the ultimate detriment of investors.”

However Vanguard did support a more detailed EU-wide regime for managing potential conflicts of interest relating to the procurement and consumption of research and recommended the report from the UK Investment Management Association on the “Use of Dealing Commission for the Purchase of Investment Research”.

Axa Investment Managers wrote that it disagreed with the proposal and it would benefit US firms who could continue to operate without Esma restrictions.

Axa IM said: “Clients of purely EU firms would be disadvantaged relative to clients of the European arms of US firms, who would undoubtedly have access to research from the US paid for through commission by clients of the US arm, which results in more, rather than less, cross-subsidy and market distortion.”

The asset managers also warned the even within the EU, some smaller investment managers that are heavily dependent on external research may be forced out of business while new entrants will face higher barriers to entry.

The US Securities Industry and Financial Markets Association’s asset management group and the Asian branch of Sifma also responded to the MiFID II consultation and said the proposal will inhibit the ability of their members to maximise the value of their client portfolios.

In the US investment firms are lawfully permitted to pay higher execution rates in exchange for research services if it enhances the quality of service provided to clients. In Hong Kong investment firms can use dealing commissions to acquire goods and services under specified conditions and there are similar rules in Singapore.

Sifma wrote: “We believe that it would make better sense for Esma to consider alternative approaches to the use of dealing commissions to procure research that take these regimes into account, since US and Asian securities markets are significant and most large European asset management firms conduct business in these jurisdictions.”

Sifma warned that European investment firms will be placed at a competitive disadvantage to their US and Asian counterparts. In particular, Sifma said US brokers will refuse to provide European investment firms with enhanced research in exchange for payment in cash and will limit their transactions to either pure “low touch” or agency deals.

The response also warned of operational and compliance difficulties for global investment firms that have a presence in Europe if they cannot use bundled commissions.

Sifma said: “It would not be economically feasible for them to apply stricter European rules on a global basis.  Faced with these complexities and compliance burdens, we believe that global investment firms would be more likely to stop operating or establishing operations in Europe.”

In addition, Sifma said that global investment firms may no longer be able to aggregate client orders on a global basis to take advantage of pricing preferences for larger orders because European transactions would have to be handled and traded separately.

“As a result, European clients of these firms may not receive pricing or executions that are as favourable as those for the US and Asian clients of these firms,” added Sifma.

Featured image via bahrialtay/Dollar Photo Club

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