The U.S. Securities Exchange Commission’s (SEC’s) decision to let its second Markets in Financial Instruments Directive (MiFID II) no-action letter expire “will create enormous problems for asset managers in Europe”, according to Mike Carrodus, CEO of Substantive Research.
Carrodus’ comments come in response to Substantive Research’s asset management survey that examines attitudes to impending structural market changes, including SEC’s decision to expire the MiFID II no-action letter in July 2023.
Carrodus’ added that the introduction of an expiration date could throw global research markets and the relationships between European and global asset managers and US brokers into chaos, with detrimental impacts to competition in the investment research market.
The MiFID II regulations that came into effect in Europe in January 2018 unbundled trading and research and pushed almost all European asset managers into paying for investment research in cash.
At that time, and in response, the SEC issued a no-action letter that allowed European asset managers to pay US brokers in cash. The letter was not intended to be a permanent solution and in July 2022 the SEC confirmed that the Division “does not intend to extend the temporary position beyond its current expiration date in July 2023”.
This means that European asset managers will no longer be allowed to pay for US broker research in cash and instead must pay through trading commissions, as their US counterparts do.
As part of its survey to gather opinion on the expiration date of the no-action letter, Substantive Research surveyed 40 asset managers — 85 per cent were European while the other 15 per cent were based outside of Europe.
The overall finding was that European fund managers and US brokers that do business with each other will be severely disrupted, with additional concern that there will be a decrease in competition in the research market, which has already been hit by MiFID II’s deflationary effects on research pricing.
60 per cent of asset managers predict the most likely outcome will be that global US brokers will be paid entirely in Europe for research consumed in both regions. Therefore, any smaller US brokers that do not have a European entity will be frozen out.
However, Substantive Research claims: “These smaller brokers simply do not have sufficient amounts of European revenues to justify fixing it all from their side, and may be seen as necessary collateral damage from the European asset managers that cut them.”
Accordingly, 68 per cent of survey participants believe that this change will mean market share further consolidates to the bulge bracket firms, further entrenching a trend of market concentration to the big brokers.
Two other possible solutions that have been suggested by industry participants include brokers becoming registered investment advisors (RIAs), or a wider regulatory fix — the SEC’s introduction of an “RIA-lite” designation that would be less onerous for brokers.
Substantive Research says this would probably reduce the time frame needed to register, and would remove key obstacles that the brokers’ compliance departments have identified. This solution was suggested in 2017, however, the no-action relief ensured that there was no need to proceed with it at the time.
Respondents’ views were split on whether brokers becoming registered investment advisors (RIAs) will solve research payment challenges, while research payment accounts (RPAs) for the buy-side are not considered a desirable option. Either way, neither cannot be implemented in time, says Substantive Research.
Commenting further on the research finding, Carrodus comments: “Many would also have sympathy with the opinion that the EU and UK Financial Conduct Authority (FCA) should be the ones to fix this, but with 27 countries needing to agree in the EU, and the FCA focused on a number of other issues, a quick exemption to be allowed to bundle trades with research for US brokers would be very unlikely and probably unworkable, if it did happen.”
He adds: “While this was not a problem of their own making, by far the simplest solution is for the SEC to listen to feedback from the US brokers and global asset managers headquartered in the US, and extend the no-action for at least another year. RIA and RPA solutions cannot be put in place by July next year, even if brokers and asset managers started working on them now.
“Without acknowledgement from the regulators that this is not something easily solvable, the likely outcome is that we will see more revenue hits for medium and smaller US brokers, and less diversity, choice and competition in the research industry. European fund managers will need to source research from an even more concentrated set of bulge bracket names than before.”
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