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Digital Subscriptions > The Hedge Fund Journal > Issue 121 - March | April 2017 > EU’s New Regime on Payments for Research, Use of Dealing Commissions

EU’s New Regime on Payments for Research, Use of Dealing Commissions

WILLIAM YONGE, PARTNER, LONDON, AND STEVE STONE, PARTNER AND BRIAN BALTZ, ASSOCIATE, WASHINGTON, DC, MORGAN LEWIS

The MiFID II regime will have ramifications for buy-side global asset managers and sell-side research providers relating to use of dealing commissions and cost allocation for research expenditures.

By far the most controversial area of the European Union’s Markets in Financial Instruments Directive II (MiFID II) reforms has been that relating to the methods of payment by portfolio managers for research produced by investment banks, brokers, and independent research providers. This reform should come as no surprise to the industry; it had long been foreshadowed in the United Kingdom by the Financial Conduct Authority (FCA), which in November 2012 highlighted the conflicts of interest faced by the UK asset management industry following the regulator’s thematic review from June 2011 to February 2012 on the arrangements UK portfolio managers had in place for managing conflicts of interest—including with specific reference to the use of customer commissions.

In October 2013, FCA announced that it was carrying out a wider review on whether reform was needed to the use of dealing commission (formerly known as “soft commission”) regime in the UK “to deliver a more transparent and efficient asset management sector for the benefit of end investors”. Following its further thematic review from November 2013 to February 2014, FCA published a discussion paper in July 2014 which featured FCA’s conclusions that

• too few firms apply sufficient rigour in assessing the value of the research services they use;

• there is a lack of price transparency in the market for research;

• the bundled supply of execution and research by brokers makes price discovery difficult;

• unbundling research from dealing commissions would be the most effective option to address the impact of the conflicts of interest created for portfolio managers by the use of a transaction cost to fund external research; and

• unbundling would drive more efficient price formation and competition in the supply of research, removing current opacity in the market.

On 3 March 2017, FCA issued a report which concluded that investment managers continue to fail to meet FCA expectations on use of dealing commissions. Broadly, the report found that the majority of the 17 firms visited were falling short on assessing whether their research is substantive, how much of their dealing commissions went towards paying for research, and whether they were spending more of their customers’ money on it than necessary. FCA noted that a few firms in the sample now pay for research from their own resources and that firms that complied with the use of dealing commission regime had seen a drop in the dealing commissions spent on research, which FCA says feeds directly into better investment performance for customers.

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