MiFID II research review - what next for firms?

Reading the FCA’s supervisory review into research unbundling, firms could be forgiven for thinking this is a job well done. But beyond the positive headlines, there are some clear messages for firms to reflect on, and the FCA highlights areas where it plans follow-up work. It is clear that the FCA will continue to assess firms as they respond and bed in the changes. Firms may need to defend their research pricing decisions to the regulator and, as we explain below, look again at MiFID II research practices in a number of areas.

To recap, under MiFID II asset managers must pay for third-party research separately from other services. This ensured that asset managers didn’t accept free research as an inducement to channel their trading execution business towards certain brokers. Before MiFID II, asset managers would effectively pay more for the same amount of research as they increased their trading volumes and would pass those costs onto their investor clients.

Asset managers should take another look at their research valuation models, with some firms neglecting their assessments of the quality and value of research. The FCA provides ‘best practice’ guidance in this area, praising firms that have, for example, mapped out payment ranges against clearly defined quality criteria, established controls to identify and escalate payments sitting outside those ranges, and have in place processes to facilitate ongoing assessment of the quality and cost of research. It would also like to see investment teams playing a central role in the evaluation process, rather than just finance functions. Asset managers must consider this guidance from the FCA as part of a review of their approaches to valuation, also using this as an opportunity to take stock of their controls around the categorisation of research material.

Related to this, the FCA found that sell-side pricing models vary considerably. A common approach is for producers of research to charge a low baseline fee for all written research - known as ‘all you can eat’ models - supplemented by explicit pricing for additional services. Previous commentary from the regulator, including Andrew Bailey’s speech on this topic in February 2019, suggested that these pricing models may be more prone to falling short of regulatory expectations, both competitively and as an inducement. The shift in tone on this in the FCA’s supervisory review findings, where it notes that this model is not necessarily unreasonable, was surprising, although the FCA will look at sell-side pricing models in 2020/21, which is perhaps a reflection of its willingness to give firms time to evolve their approaches.

Sell-side firms should use this time to look again at their pricing models. In particular, they must establish a process to assess whether each piece of research could effectively be deemed an inducement or inappropriate from a competition perspective. Firms must be able to robustly defend their judgements on pricing to the regulator. Some firms are turning to automated solutions to provide an integrated framework that brings together the large volume of data necessary to support these decisions. This type of tool may also be helpful to buy-side firms to support with valuation decisions.

More broadly, as the reforms continue to bed down, firms should keep under review their strategic decisions related to research. For the buy-side, this means looking at their research consumption decisions, focusing on research that adds value to their investment strategies and delivering value to clients, as well as decisions around in-house research production and the use of research aggregators. The sell-side should consider monitoring their coverage areas, prioritising the production of material that is of greatest value to buy-side clients and the markets.

So, it is clear that the FCA’s work here is not yet done, with ‘phase 2’ on its way in 18-24 months’ time. By that time, market practice is likely to have developed further and we can expect the regulator to have a clearer view on whether firms are meeting expectations. Firms should not sit back, but instead keep under assessment whether these evolving practices are likely to satisfy the FCA and, ultimately, continue driving good outcomes for consumers.

Lucas Penfold

Lucas Penfold | Manager
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