Cowen’s Westminster RPA team recently gathered senior-level clients in an open forum to garner actionable insights into how buy-side institutions are dealing with research unbundling following the 3 January, 2018 MiFID II implementation date.
The thought-provoking discussion was led by Robin Strong, Managing Director of Westminster RPA and Chris Tiscornia, CEO of Westminster Research, and following are key highlights:
(No quote attribution is given to any of the managers in attendance for confidentiality reasons.)
Research pricing
In the second half of 2017, the media seemed to primarily focus on how sell-side institutions would price their research. This was uncharted territory for an industry that traditionally provided research in a “bundled” manner alongside payments for trade execution. As the buy-side and sell-side explicitly negotiated the price of research, the figures mentioned publicly varied widely – from annual subscriptions of less than GBP10,000 for entry level access to GBP1,000,000 for premium level access. For smaller managers, these higher-end subscription costs were simply not viable and this huge bid-offer spread resulted in a period of price discovery for the industry. In many cases, brokers began to offer low cost read-only access to research written by their analysts, with premium services such as one-on-one calls, financial models and conferences priced as higher cost items. This spectrum of available services at different cost points provided the basis for managers to prepare budgets to communicate to their clients and internal stakeholders.
A degree of flexibility will be key to both the buy-side and sell-side as they finalise their research budgets. Much will depend on the evolving broker vote processes that are undertaken periodically over the course of the year. Of course, many managers have negotiated fixed price agreements and will have to deal with additional services beyond the scope of their initial contracts. Managers might ultimately end up paying more to a research provider if they are contributing more value and voted higher than expected or vice-versa.
The clients in attendance agreed that by Q4 2018, there will likely be a second round of negotiations once there are more data points to help analyse each broker relationship. This could be just as intensive as the first round of negotiations from Q3/4 2017 and it remains to be seen whether managers will take the opportunity to re-evaluate the sources of their research.
Consumption tracking
Another important topic of discussion amongst the clients in attendance was the range of tools being used to manage their firm’s research consumption – some are managing the process on internally managed systems, while others are using third-party providers who aggregate and cleanse this data. Regardless of the approach, it is still a labour intensive process and firms are often reluctant to devote significant resources to this process. Most managers are comfortable with an evolution of the traditional “broker vote” process, where their investment professionals assign votes at the end of each quarter to indicate their assessment of the usefulness of the interactions from each provider, which can ultimately help determine the level of payment to each.
Several clients referenced third-party tools that extract meeting and call information to help automatically generate summary reports. Being able to track and evaluate research interactions dynamically will make things less operationally intensive. Most attendees agreed that having a robust process in place to automate research consumption will become an important part of the research budgeting and valuation process.
It was further discussed that no matter what consumption model managers use, they will need to defend why they are paying their clients’ commissions to a research counterpart. Many felt that high-level summary reports would be acceptable methods to assess the value of research interactions and to justify the amounts that they are paying to their research providers.
Account funding
According to the MiFID II funding requirements, the provision of research is not considered an inducement if managers use one of three funding options:
• P&L – manager pays for the research themselves
• RCCA model (“transactional method”)
• Swedish model (“accounting method”)
Amongst the managers who attended the breakfast, the number of clients using the transactional method was roughly split evenly with those using the accounting method.
For clients using the transactional method, many questioned the need for the requirement that all RCCA credits be swept into the client’s Research Payment Account (“RPA”) within 30 days. Several clients noted that the process was creating an enormous amount of unnecessary pressure and work for clients, brokers and administrators to ensure that funds are swept within the time period required by regulators.
Several clients using the accounting method asked if it was a regulatory requirement to physically transfer funds to the RPA monthly if the research fees are accrued monthly, or if they can wait until they receive physical invoices from the research providers.
Robin Strong stated that “there isn’t anything in the regulations that stipulates a frequency of transfer for clients using the Swedish model, but clients should accrue for the charge every time they price the fund and then, at an agreed-upon frequency, transfer the monies into the RPA.” Most clients will do this quarterly if they have a formulaic method to determine research spend.
VAT processing
The big question surrounding VAT was whether this cost gets absorbed by the manager or the fund (and therefore the end investors)? There is no definitive answer to this. Some clients have been able to negotiate in writing that the price agreed with their research providers includes VAT, while others have to handle a 20 per cent uplift, with variable tax rates applying for research sourced from outside the UK.
Currently, the preferred route appears to be that the management company pays the VAT and then reclaims it, regardless of how the RPA is funded. If the total research budget across all funds for that quarter is GBP100k, for example, the management company would contribute GBP20k to add to the GBP100k charged to the funds. Westminster would settle the invoices for a total of GBP120k and the management company would attempt to reclaim the VAT from HMRC.
The alternative approach of the funds paying VAT and the management company attempting to reclaim on their behalf is a viable approach, but adds significant accounting challenges for many firms, depending on their legal structure and accounting practices.
The bottom line is that MiFID II has driven up the cost of research for many managers. As such, the best guidance is to prepare for a worst case scenario and make a provision in the budget for the VAT charges. If the management company is able to reclaim the VAT this minimises the charges to their clients. If the RPA has been funded such that it can cover the additional VAT costs (this is not required), the residual balance can be rebated back to the funds at the end of the year or rolled-forward to the next budgetary period.
Client reporting
In brief, under the regulations an underlying asset owner can demand, at any point, an analysis of how their assets are contributing to the fund’s research expenditures. The general consensus was that managers are choosing to formally report to the board of directors on a quarterly basis but that specific investor demands will be rare and dealt with accordingly.
“If we receive a specific request from a client, we will produce a fund report but at the moment reporting is at the Board of Directors level,” said one fund manager.
Quality of service post-MiFID II
One final topic of discussion focused on whether there was a noticeable change in the level of service provided to the buy-side. One manager confirmed since his firm had signed up for entry-level research, financial models that had previously been included in the package were no longer being provided.
Independent research providers and smaller brokers are being more selective and granular when compared to the bigger shops, and are more likely to change their prices if the number of users changes, remarked another fund manager.
The service experience also extends to the way managers and brokers communicate with one another. There can be no inducements under MiFID II, meaning managers have to take greater responsibility with receipt of research content and formally tell brokers they have to pay for a piece of research – even if it’s a nominal amount – to make sure no one is breaking the rules. Alternatively, they have to ensure that future materials that have not been paid for are not utilised and, potentially, blocked.
It might be that the portfolio managers have historically received research which they’ve used and which they still regard as substantive research. Now it’s a case of, ‘Let’s agree on a price so that we can still receive it, especially if it is fundamental to the research process.”
Summary – Below is a recap of the key takeaways from the discussion:
• The MiFID II regulations are gradually having their desired effect, but a lack of operational guidance from the regulator has resulted in different approaches from different firms.
• Larger firms have generally been able to maintain their existing research relationships but smaller firms have had to make more changes to manage their spend.
• Research consumption tracking and quality evaluation is an evolving space and firms are refining the balance between granularity of assessment and the resources and effort required to do this efficiently.
• Ongoing quality assessment will result in quality providers flourishing and the new regime will create opportunities for niche and independent providers.
• Research providers have had to become innovative with their pricing and service tiers, recognising that different clients will require different solutions.
• The introduction of VAT on research purchasing has reduced the overall wallet and has added operational challenges for some firms.
• MiFID II has been straightforward for some firms and painful for others but the market has made the necessary initial adjustments and will continue to evolve during 2018 and beyond.
