Acknowledging that high-quality, easily available investment research supports deep capital markets, listed companies, and economic growth, the UK Financial Conduct Authority (FCA) recently issued a consultation paper proposing to give UK buyside firms an additional option for how to pay for investment research. The so-called “new” option allows for the bundling of payments for third-party research and execution services, known variously as “bundled research” or “payment bundling.”

Bundled research was banned under the Markets in Financial Instruments Directive 2014 (MiFID II) in 2018, causing considerable upheavals in the EU, UK, and globally for the buyside in particular and creating challenges for cross-border payment for US-generated research and global firms with affiliates in Europe and the United States.

Historically, before MiFID II, brokerage firms in Europe, similar to their US-based peers, typically bundled research costs with execution commissions. MiFID II introduced requirements to separate charges for execution and charges for research, thereby unbundling these two services, as part and parcel of banning bundled research.

The proposals [1] are potentially relevant to investment firms and market operators in the UK, asset managers, institutional investors, insurers, banks providing investment services, and research providers that are not FCA-authorized. The scope will initially not include managers of alternative investment funds and UCITS funds acting as such, but the FCA’s intention is to bring them into scope pursuant to a future consultation later in 2024.

POST-BREXIT RECOMMENDATIONS OF THE INDEPENDENT RESEARCH REVIEW

As part of the UK government’s post-Brexit Edinburgh Reforms to drive growth and international competitiveness in UK financial services, the government commissioned the Independent Research Review (IRR) to evaluate the provision of investment research in the UK and its contribution to the international competitiveness of the UK’s capital markets, considering, e.g., the impact of unbundling under MiFID II on the supply and demand for research services.

The IRR published its recommendations in July 2023 (1) concluding that unbundling had adverse impacts on the provision of investment research in the UK and reduced the access of UK asset managers to global investment research by preventing them from purchasing research from jurisdictions that operate a bundled model, placing them at a competitive disadvantage against their international peers; and (2) recommending bundled research be reinstated as an option alongside the two current options under the FCA Rules (and, from an EU perspective, MiFID II) whereby payment for research must either be

• made by the investment firm receiving the research from their own resources (the P&L model); or
• charged for separately through agreement with the client under an operationally compliant research payment account funded by research charges levied separately on each of the investment firm’s clients (the RPA model).

In practice, many asset managers, in particular the larger ones, chose the P&L model, mainly due to their ability to absorb the costs of research on behalf of clients but at least partly due to the operational complexity of the RPA model. Interestingly, the RPA model saw material take up from hedge fund managers.

BUNDLED RESEARCH GUARDRAILS

The FCA proposes to permit FCA-regulated investment firms, alternative investment fund managers, and UCITS managers, in respect of MiFID business they perform for clients other than any fund for which they act as manager, to make use of bundled research as a payment option, provided that they comply with certain guardrails:

• A formal policy on use of bundled payments, including with respect to governance, decision-making, and controls and how these are kept separate from those for trade execution;
• Written agreements with research providers addressing the methodology for calculating and separately identifying the cost of research;
• A budget for the amount of third-party research to be purchased, with ongoing assessments of research value and price;
• A structure for the allocation of payments among research providers, similar to the pre–MiFID II commission-sharing agreement model;
• An approach to the allocation of the costs of research purchased by bundled payments across clients, ensuring that the costs incurred by any client are proportionate to the benefits received by it, to mitigate the risk of cross-subsidisation across investment strategies, client types and where clients consent to different research payment options (for example, some consent to a bundled option but others do not);
• Operational procedures for the administration of accounts used to purchase research; and
• Disclosure to clients on the firm’s use of bundled payments.

In addition and unrelated to the IRR, the FCA proposes to

• classify short-term trading commentary and advice linked to trade execution as types of acceptable minor non-monetary benefits for all three payment options and thus not subject to the ban on inducements, an intended outcome being that UK investment firms may receive such product from US broker-dealers and investment advisers; and
• delete the option for bundled payments to purchase research on companies with a market capitalization below £200 million from the list of acceptable minor non-monetary benefits on the basis that it has had “little take up” and the “new” option for bundled research applies to research on companies of any size.

The consultation period ends on June 5, 2024 and the FCA intends to finalize the rules soon thereafter by the end of June. However, it is not yet clear when the FCA would bring the new rules into effect. It will be important that as part of the consultation process the FCA considers industry comments about the likely logistical considerations in complying with the various proposed requirements and how they deviate from legal standards elsewhere, including how the requirement that costs be allocated fairly aligns with the legal framework in the United States, which does allow cross-subsidisation.

Generally, asset managers currently relying on the P&L model will likely tread carefully before transitioning to client-funded bundled research until likely client reaction can be gauged. Asset managers relying on the RPA model will be more confident about a transition to the proposed new bundled option to lessen the operational complexities and expense that accompany the RPA model.

EU APPROACH

The EU is treading a similar path to the UK, albeit on a less urgent timetable, with the European Commission noting in December 2022 that, further to the introduction of the unbundling rules,

• independent research had become unsustainable due to low prices charged by some larger providers; and
• research coverage of small and medium capitalization companies shrank.

The European Parliament formally adopted the text of a new EU directive (as agreed by the EU institutions) on April 24, 2024 that would amend MiFID II to allow rebundling of payments, labeled “joint payments,” as an alternative to “separate payments” using the P&L model or RPA model and expressly carve out sales and trading commentary from the scope of investment research.

On guardrails, the EU approach shares certain features in common with the FCA, e.g., transparency about the payment option selected by the firm, maintenance and disclosure to clients of a policy to manage conflicts of interest, regular assessments of the quality and value of research, an agreed methodology for separately identifying charges for research from trade execution, disclosure to clients of costs, the exclusion of sales and trading commentary from relevant guardrails.

However, the EU reforms do not follow the FCA’s proposals relating to setting budgets for research spending, allocation of costs across clients, or a structure for the allocation of payments across research providers. The new directive is on a path to becoming law later this year, with the final step being adoption by the Council of the EU, which is thought likely to happen in Q4 2024.

The new directive provides an 18-month period for transposition into local member state laws, which could mean the reforming measures may not fully bite across the EU until H1/26, in contrast with the FCA’s measures that are currently scheduled, perhaps ambitiously, to be finalized by the end of June 2024.

[1] CP24/7 “Payment Optionality for Investment Research.”

[View source.]