Reasons fund managers need to worry about MiFID II and MiFIR (part 2)
Last week, I drew attention to the massive inflation of regulatory reporting obligations introduced under the updated Markets in Financial Instruments Directive (MiFID II) and the accompanying Markets in Financial Instruments Regulation (MiFIR).
This week I want to draw the attention of members to a potentially major change in research procurement that may occur as a result of MiFID II and MIFIR – and to a potentially large change in what is reported not to regulators, but to clients.
The MiFID II Directive published in January 2014 indicated that dealing commissions should be used to purchase only “minor non-monetary benefits.” As far as research is concerned, that implied dealing commissions could be used to purchase only that research where there was demonstrably no conflict of interest, such as general macro-economic research.
The ESMA consultation paper published by the European Securities and Markets Authority (ESMA), which contains the advice of the regulator to the European Commission on the Level 2 measures in MiFID II, says using commissions to buy investment research will not count as a “minor non-monetary benefit.”
This echoes the steps taken recently by the Financial Conduct Authority (FCA) in the United Kingdom. After a consultation paper (CP 13/17), and a “thematic review” last winter, the FCA announced in a policy statement (PS 14/7) in May this year – see http://cooconnect.com/dominic-hobson/fca-puts-an-end-to-investors-paying-for-corporate-access - that managers should use equity dealing commissions to pay for “substantive” research only. That did not include “corporate access.”
The FCA has since published a further discussion paper on the use of dealing commission (DP 14/3) that makes clear its own distaste for managers using client-owned equity commissions to pay for research (including corporate access) had a chance to be enacted at the pan-European level via the revised Markets in Financial Instruments Directive (MiFID II).
“Conduct” issues of exactly this kind are one of the major themes of MiFID II. The expectation is that European managers will soon be obliged to pay for non-minor or substantive research from independent research providers using their own money. But this unbundling of dealing and research purchases has some way to run yet.
Both ESMA and the FCA understand that a ban on equity commissions in one country would have much the same effect as socialism in one country: everyone would go and work somewhere else. In fact, any meaningful limitation on the use of equity commissions to buy investment research ultimately depends on regulators in the United States electing to follow the European example.
In a related, but equally significant development, the MiFID II consultation paper also contains an entire section (2.14) devoted to what information should be disclosed to clients on transaction costs and charges. The proposal is that costs and charges will be itemised individually and aggregated, and expressed as both a cash amount and a percentage of the investment.
This would raise the concept of an expense ratio to a whole new level. It offers the prospect of investors being told on an annual basis the cash value of all of the management fees, dealing commissions, spreads, and other charges and expenses incurred on their behalf, and how they were collected or paid. Dealing commissions, as a payment to a third party, will have to be disclosed. The impact of the costs on investment performance will also have to be disclosed.
A list of the costs to be disclosed, abstracted from Annex 2.14.1 of the ESMA consultation paper, appears at the foot of this article.
The original intention was that full cost disclosure would apply to retail investors only (Article 33 of MiFID II, which sets out full disclosure, restricts it scope to retail investors) but ESMA says in the consultation paper that “increased transparency is relevant for all categories of clients, including non-retail clients. Therefore, ESMA proposed that the implementing measures proposed in this chapter should apply, in line with the MiFID II text, to all categories of clients.”
Non-retail clients will be free to opt out of the disclosure, except when buying portfolio management services or derivatives. Managers can also avoid disclosing costs for which they are not responsible. For example, an institutional investor that chooses their own custodian, rather than using one supplied by the manager, should obtain and manage its own custodial costs.
These proposed disclosures are part of a wider shift on a global scale to greater transparency for investors, and which are based on the regulatory perception that information asymmetries between intermediaries and their clients are too great. The United Kingdom, for example, is about to oblige greater disclosure of costs incurred by investors in defined contribution pension plans.
Regulators are now obliging fund managers to tell investors exactly what they are paying for the service. Until disclosure becomes effective, it is impossible to say what impact this will have on the relationship between managers and their clients, but it is hard to be optimistic.