Part 1: New wave of pressures for ‘transparent’ execution and research
Regulatory changes to the transparency of the cost of research and the pressure to achieve best execution are driving innovation in the financial industry, as both service providers and service consumers consider their options. The concept of unbundling research services from the choices made for routing execution flow is encouraging a fresh view of two important measurement areas: the quality of broker services received and their relative value to firms’ investment strategies and clients. The effects of segregation mean that the price of research will be recognized as a separate cost. Focus on pure cost of execution is fueling competitive downward pressure on sell-side companies. The combined impact of these change drivers is leading to the buy side taking greater control in deriving maximum value added services from their brokers.
Regulatory expectations of investment research
One of the objectives of the Markets in Financial Instruments Directive II investor protection regulation (MiFID II) is to ensure that clients are transparently charged for services fairly and proportionately. This goal is particularly challenging for the financial services industry today, in two specific regards. First, the distribution of investment research is opaquely priced, even though it carries significant value. Second, it has the potential to cause conflicts, because it can influence decisions to select providers of other services, namely execution. The regulations requiring that services are distinctly priced and disclosed to clients transparently place increased scrutiny on service providers to ensure that appropriate control is in place for fair pricing and that charges represent add value for clients.
Regulators in Europe are introducing concepts that will demand transparency of research and execution payments, along with service proportionality. This will impact the full value chain from sell side to buy side, service providers to service consumers, institutional flow through to individual retail client transactions. With their definition of the “Research Payment Account,” the regulators aim to mitigate the conflicts inherent in receiving the nonmonetary benefits of “free” research. The regulators also seek to ensure that there is clarity around budgeting, controls and quality of services consumed in exchange for client payments.
Many of the challenges imposed on the financial industry stem from the requirement to ensure that any services engaged and decisions taken are “in the best interests of the client.” This foundation stone of MiFID II places the burden of control resolutely with the investment firm providing their services to the end-client. With the greatest degree of protection offered to retail clients (nonexperts in the markets or professional institutions), the regulators require disclosure of fees pre-trade. This is to allow clients enough information to judge whether they would like to proceed with a transaction, service or product, informed by full visibility into all associated costs and charges. This increased scrutiny of individual charges has prompted companies to revisit the costs incurred along the full value chain.
As with all industry shakeups, the result will include opportunities to help turn regulatory change into a competitive advantage for, or a strategic enhancement of, existing business models. Interestingly, the focus on transparency of segregated costs has encouraged many companies to start evaluating how much they spend on research or execution – and how much merit there is in this investment. Within execution services, new levels of scrutiny are driving costs down in a race to the bottom, to retain the valuable order execution flow. In the case of research, re-evaluation is leading consumers to frame clear criteria for value added services, an initiative which should have happened years ago. After decades of de facto undermining of the worth of research, with the industry giving it away for free or as an inducement for handling order execution flow, now we see the beginnings of pricing research as a service, one accorded the significance it deserves.
Going forward, given such an established legacy of combined services provision, how can buy-side firms ensure they receive the best value in the context of future service decoupling of execution and research?
Best execution services under MiFID II
Selecting a broker for execution services is an important decision for a buy side-firm, given the requirements to demonstrate an effective best execution framework, a measure that has been in place since MiFID I. MiFID II may arguably imply a strengthening of best execution monitoring, because the text of the regulations is amended from all “reasonable” steps to all “sufficient” steps required for delivering the best possible result for clients. This protection is most applicable to retail investors. However, the value chain also extends directly to sell-side and to institutional brokers who seek order flow to provide liquidity to the venues while aiming to reduce execution costs where possible. In this new landscape, how does a buy side firm define success when it comes to measuring their execution services providers?
Under MiFID II, executing brokers have a duty to direct the order to the venue with the best possible price for the client. This is a challenge when an array of venues can execute orders, including internal crossing networks (systematic internalizers). Add to this challenge that exchanges encourage sell side brokers with enticing pricing models, and now there are multiple, conflicting motives when it comes to routing even the simplest order. Over the last few years, the number of vendor solutions that accurately measure execution quality has expanded, with complex volumes of data used to calculate the opportunity cost for each transaction. This allows the buy side to measure the success of its brokers. More importantly, it also provides the buy side with evidence with which it can demand enhancement to its broker service offerings to benefit their end-investors.
The results of these complex, often post-trade comparison metrics can also help develop more sophisticated pre-trade order routing mechanisms. Smart order routing methodologies automatically make decisions based upon predefined scenarios. Humans are now involved in fewer decisions around execution routing selection, and this electronic world is arguably faster, more traceable and less prone to error. The best of the most sophisticated execution tools include defined models to measure the success of smart order routing capabilities. This has proven especially important for institutional buy-side firms, such as asset managers, when managing the costs of executing larger transactions. Recent studies have demonstrated that these firms can benefit financially from detailed transaction cost monitoring to maximize their fund performance and optimize their rankings for investor fund selection.
Provision of research services under MiFID II
Even the definition of “research” poses a challenge. Yet, a clear understanding of the output is a foundational requirement for service scoping, pricing and quality assessment. The regulatory environment has offered guidance on how to distinguish the outputs of a research provider by categorizing its components, including: material concerning one or several financial instruments that are closely related to a specific industry or market, and provision of views on financial investments, assets or issuers. The material referred to in the guidance is expected to, explicitly or implicitly, recommend or suggest an investment strategy, together with a substantiated opinion, and to offer insights into the future value or price which could be used to inform an investment strategy. Ultimately, the assessment hinges on whether this material is considered to add value to the investment firm’s decisions on behalf of the clients being charged for the research.
By comparison, so-called nonsubstantive material may include short-term market commentary or the latest company results or economic statistics. The access to and accuracy of this type of information is often a measure of quality within a provider of execution related services. Broker insights or morning market notes are often valued as providing knowledge to the buy side from traders in the market on the sell side. Therefore, given the tooling for measuring value, these services are more likely to be measured through the execution services tooling. The regulators have concluded that these types of output are minor nonmonetary inducements and thus do not require specific payment and, because of the public nature of their information, are considered of low value to the investment firm.
The new MiFID II regime offers two ways to subscribe to research services: buy directly from the firm’s own resources or buy using client funds drawn from a research payment account. For companies who choose to use client funds to pay for research, MiFID II has stringent requirements for managing this research payment account. These include defined budgeting, policies and controls for quality, disclosure of costs at a client level (clearly segregated from the execution charges), senior management oversight and a documented approach for applying the costs fairly across the client portfolios, including rebating or carryover of unspent budget. These onerous controls even extend to the publication of the full budget, with allocated amounts clearly identified to each research provider. For a buy-side company, this can mean revealing competitive information about third-party pricing arrangements and company-level negotiations.
Alternatively, an investment firm can choose to pay for the research directly with its own resources. It can then determine whether these charges will be passed on to clients with an increased fee within their overall service model. This route avoids much of the complexity of client-level disclosure while retaining full discretion over the charges and providers included in the selection of any third party research consumed. Because the nature of direct payment mitigates many of the conflicts referenced above, there is no need to transparently manage the research budget (given external notification to the clients in the case of an extended investment). This approach would allow the firm to make their corporate spending judgements within their own regular, internal cost control environments.
Part 2 of this three-part blog series considers how the value add provided by research can be assessed accurately and charged for equitably.
Natasha Leigh Giles is a Managing Principal at Capco Switzerland with almost two decades of experience in the financial industry. Having started on the trading floor in wealth management, she now leads business and technology change programmes, from definition to implementation, across front, middle and back office.
The content and opinions posted on this blog and any corresponding comments are the personal opinions of the original authors, not those of Capco.