The compliance date for implementation of MiFID II in Europe saw many investment managers kick off their new transaction and trade reporting implementations. Another big portion of MiFID II, signaling many firms to overhaul their commission management systems, continues to pose a challenge for many firms using commissions to pay for research.
In a nutshell, MiFID II rules mean investment firms must account for the research dollars they spend, as brokers can no longer be rewarded for research services through payment of trading volume. Prices for research must be determined, budgets set, and spending allocated, tracked and reported to end investors. While these changes should certainly bring about more clarity, less noise, better distribution and better quality control over research, they also mean commission management automation is now a must at most firms that fall under the scope of MiFID II.
This framework has to be incorporated into a firm’s process even if the decision has been made to pay for research through an RPA or via P&L – something that has miss-interpreted within the market.
A consequence of paying through P&L will inevitably see a reduction in research consumed which in turn could see a reduction in returns, both short term and projected, so it’s even more important to make sure, and prove, to investors that the research consumed is continuously providing firms with the maximum possible Alpha.
The US are in a slightly advantageous position as they are essentially second movers. The Securities and Exchange Commission has issued a series of ‘no-action’ letters to permit U.S. broker-dealers to provide separately paid-for research services for European clients, alongside existing bundled commission arrangements for U.S. clients, for a period of 30 months. Furthermore, the SEC announced it will study the effects of MiFID II and consider whether any permanent changes to its securities laws are appropriate. Even if nothing comes of it, already we’re seeing some asset managers making their approach to commission management in the U.S. more transparent in line with EU guidelines, and we believe this will continue to evolve along with business practices at global firms.
So, what are the key aspects of commission management that need an adjustment under MiFID II? And how can they be managed better with technology?
Trade Commission Tracking/Unbundling
This is the very basis of the commission management regulation. Investment managers can no longer just bundle the research cost into the overall commission: execution and research must be evaluated separately, and each payment stream must function independently. Therefore, it’s critical to automate the process, choosing a robust platform that can perform execution and research tracking equally well. This becomes more complex in the cases of payment for third-party research, even if the executing broker chooses to pay those costs directly. MiFID II makes clear the onus is on the investment manager to account for all commission payments and ensure end investors are well-served.
Setting a Budget
One of the biggest changes to the bundled commission management approach to come out of MiFID II is the requirement to set a research budget in cases where research is paid for through commissions. That means investment managers must set up separate accounts, which are then set up to pay out client funds to specific brokers.
This means that both the service provider and research evaluation process must not only be robust and continuous but also flexible enough to be built according to bespoke and complex corporate structures which in turn documents strategy for distributing funds according to quality.
Moreover, MiFID II rules require constant reevaluation of the research arrangements, and consistent reporting to the client, with the ability to adjust the research budget based on the client’s needs and wishes.
Budgeting under MiFID II is fluid and complex, and is best served by an automated system that specializes in tracking research valuation changes and allows the investment manager to readjust the budget simply and easily.
Establish a Valuation Framework
As the requirements of budgeting might indicate, ongoing, thorough broker votes are a central part of the commission management process. One of the is biggest complications around evaluating research is that it can take many forms: written documents, valuation models, idea generation, investor meetings and sales team investigations, to name a few. The benefit or value of the research is also up for interpretation and dependent on the target audience. To be truly effective, all voters should have good insight into how effective or valuable a service provider’s research is to an individual, team or sector, and be able to justify the vote, and assign a dollar value to the research.
A trend we may see more of in 2018, predominately in hedge funds but also among other asset managers, is outsourcing. The quantity and quality of different service providers has reached the level where asset managers are increasingly attracted to outsource many parts of their business infrastructure as well as some research-and investment-related activities. This includes IT, legal, compliance, third-party marketing, back office, data providers, and analytics. Again, under MiFID II rules, values for these services must be assigned, tracked and budgeted, which is best handled by a central, flexible automated system. For instance, within Eclipse Commission Management, we’ve built bespoke reviews that evaluate such entities based on custom question criteria.
Last but not least, the system you choose to track commissions should be able to manage commission payments. Once again, the onus under MiFID II is on the investment manager to ensure the relevant parties are paid fairly and in accordance with written policies governing commission management. Payments must take place in accordance with research valuation, and then be fully audited, recorded, and reported back to the end investor. Handling this process separately from budgeting and evaluation risks unnecessary reconciliation work and creates potential for mistakes, which can be avoided by using a single system to handle the lot. When choosing such a system, ensure that there’s built-in flexibility to change providers, adjust payments or explore new sources of research.
The Way Forward
At Eze, we continue to take an active learning approach, and continuously evaluate our Eclipse Commission Management roadmap as the industry adjusts to the research requirements articulated under MiFID II. When we reimagined our commission management capabilities in the cloud and reshaped them for MiFID II last year, we envisioned a platform designed to handle the full commission management lifecycle, from research evaluation to budgeting, unbundling and specifying payments.
The roadmap for Eclipse Commission Management remains fluid but we feel the key for clients is to provide software that allows them to both aggregate and manage consumed research from multiple sources but tie that with their own ‘interpretation’ of a broker vote so that each piece of research (and the provider) can be both monetized and evaluated. One of the many advantages of the cloud is adjustments are easy to implement. We are flexible enough to shape the direction of the product in a manner that addresses what works and what doesn’t. This, of course, means we are working closely with our end users and developing the product based on evolving feedback and requirements.
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