Research Payments in Europe: Can CSAs Survive?

Asset managers of European funds may be breathing a sigh of relief thinking that European regulators will allow them to keep their commission sharing agreements (CSAs) to pay for research they use to make investment decisions for their clients.

The reality is not so simple. As currently implemented, the CSAs may not comply with all of the new requirements listed under “delegated acts,” specifically under the category of “inducements.” The European Commission wants to make certain that investment funds benefit from whatever research their asset managers buy to make their trading decisions and understand what they are paying for.

Among the EC’s concerns is that asset managers shouldn’t be trading with brokers, strictly based on the research they provide. Likewise, research costs should not be tied to transaction volume. For CSAs to continue to be used by broker-dealers and their asset management clients, the operating rules will have to change.

The issue of how to pay for research is part of the second incarnation of the European Markets in Financial Instruments Directive (MiFID), the massive regulatory initiative devised to reduce systemic risk, increase transparency and protect investors. As of January 2018, asset managers will have to decide whether to pay for the research themselves or have their clients — the ultimate end fund– do so. If the fund clients pay, the fund manager must set up a research payment account (RPA). The individual fund clients of the fund manager can agree to fund the RPA through one of two ways. One is the accounting method which will rely on fund clients agreeing with their fund manager to a fixed research charge taken from the account. That means the fund manager must ask its clients to fork over hard cash. Alternatively, the fund manager can take the monies out of commission payments the funds make.

Some Relief

The EC typically relies on the pan-European regulatory agency, European Securities and Markets Authority (ESMA), to craft the final language of how its directives will be implemented. The original language of the “delegated acts” would have prohibited asset managers from pay for research out of commission sharing agreements (CSAs), in which the asset manager charges each investment firm a bundled or combined fee for both trade execution and research. Fund managers would have been required to pay for research on their own or to ask individual funds to pay in hard cash. Ultimately, the EC relented after much criticism from fund managers and broker-dealers concerned about the potential harm to smaller fund managers who didn’t have deep pockets and research providers who might not be able to offer research on all types of traded assets.

The EC’s final decision balances investor protection with practical considerations. “The research payment account should only be funded by a specific research charge to the client which should only be based on a research budget set by the investment firm and not linked to the volume or value of transactions executed on behalf of clients,” says the Commission. The EC also says that there should be a definable research charge linked to a transaction — a stance which gives asset managers leeway to use CSAs to pay for research. The US Securities and Exchange Commission has taken a more lax view on research payments ruling that fund managers of US funds can pay for research out of client commission agreements, the US version of CSAs, as long as the research falls within how the SEC defines research. For example, fund managers cannot use the money to pay for computer hardware.

Although the EC is not explicitly prohibiting using CSAs to fund research payments, as many European fund managers had once feared it would, fund management firms would still need to adopt stricter controls and governance policies over their research spend, according to Amrish Ganatra, managing director of Commcise, a London-based commission management software firm which just opened an office in New York. An estimated fifty percent of European fund managers already rely on CSAs to pay for research.

Here is what the EC says asset managers will now be required to do if they use investor monies to pay for research: tell their fund clients how much money they will spend on research in advance, breakdown to the fund how much of its commission dollars went to research on an annual basis, and regularly assess the quality of research they consume to ensure it helps the investment manager to make better decisions to benefit the end fund.

In a typical CSA, the fund manager works out how much of the commissions will go toward paying for trade execution and how much for research with each broker-dealer and research provider. Depending on how the CSA is handled between the asset manager and the broker-dealer, the asset manager might not be fulfilling at least one of the EC’s critical requirements — that the asset management firm has control and is responsible for the research payment account, which would mean that it must do the same for the CSA.

Although the asset manager might now reconcile its books with those of the broker-dealer, that might not happen on a trade by trade basis, as the EC rules would require, says Ganatra. The EC’s rules also suggest that the asset manager must insist that a broker-dealer ringfence CSA funds from its own provide some form of protection in the event the broker-dealer goes bust. Some broker-dealers now keep CSA balances on their balance sheets. European fund management shops and broker-dealers contacted by FinOps Report declined to discuss whether their CSAs complied with the control requirements of the EC’s rules, saying they are “evaluating” their current arrangements.

Tough Choices

So what’s a fund manager to do? Having a conversation with a broker-dealer to ensure the CSA complies with the terms of the EC’s control requirements is a good start. Fund managers can also rely on commission management systems to help them manage and fund their research payment accounts, but they must ensure the systems will help them also evaluate the quality of the research received. Asset managers must ultimately answer the question of whether the research helped them make the best investment decision possible. Last but not least, the commission management software must help the asset manager report back to each fund client where the research monies were spent.

Yet another option for fund managers: taking the outsourced approach and relying on CSA aggregation or administration firms to handle multiple broker-dealers and research providers. However, such aggregators typically address only how research payment accounts are funded. They do not evaluate the quality of the research, nor do they provide reports on how much money is spent by each research firm on what type of research. Those two requirements are still left up to the fund manager to handle.

Insisting that fund clients pay for research themselves in hard cash  — the accounting method — appears to be the easiest way for easiest way for fund managers to keep track of how much is being spent for what research by each fund on a monthly, quarterly or even daily basis. Individual funds clients should find the transparency refreshing. Not so for a fund manager, who will need to keep a tight reign over its research spending to ensure that it doesn’t spend more than the fund paid for. Of course, the fund manager would also have to negotiate with the fund what its  research budget will be in advance down to the last cent and seek permission from each fund if it needs to increase the amount down the road.  Compliance specialists at European fund management shops tell FinOps that asking for clients to pay for research out of CSAs, will be so much easier than asking for hard cash even if it takes a bit more work to accomplish.

Among the factors fund managers should consider in making a decision on how to fund their research needs is the number of investment funds managed, their legal jurisdictions and the type of fund involved. If the fund manager handles only US investment funds, no problem. It doesn’t have to worry about the European rules. If it handles only a handful of European ones, it can always rely on the client’s hard dollars to pay for the research or CSAs, says George Bollenbacher, director of the regulatory practice for Capital Markets Advisors in New York.

Cross-Border Challenge

The far bigger challenge will be for global asset managers with funds domiciled on both sides of the pond. “Global fund managers servicing US and European funds have the most difficult challenge of deciding whether to implement a single regulatory regime — the European — than use two separate ones which would require them to follow two separate ones,” says Bollenbacher. “Those with US and European clients wanting to follow both US and European regulations would need to divide the research payments between the two types of client bases, which could prove operationally difficult.” The reason: fund managers would have to adapt their order management systems to flag which customers are US based and which are European. They would then amend the terms of their each of their investment contracts with each fund client.

Some fund managers might ultimately decide to just rely on the European rules for all of their clients for the sake of consistency.If that is the case they will then have to decide whether they want to fund the RPAs through CSAs or client’s hard cash. Chances are they will pick CSAs, because they are universally-accepted funding mechanisms.

Operational issues aren’t all fund managers should consider in making their decision on how research should be paid. That’s just scratching the surface of their new responsibilities, asserts Rebecca Healey, research consultant for Tabb Group in London. “They should also consider how they will justify the value of research to their clients. That may be an even harder proposition.”

She cites the following examples of potential quagmires: what if a fund manager purchases research simply to validate it made the right investment decision after the fact. It never used the research to make the decision in the first place. Yet another: What if the fund manager follows the recommendation of the research to buy a particular asset only to discover it was wrong. The price tanked. What then?

Broker-vote platforms provided by commission management software firms can only help the fund management firm vote on who should receive its research funds, calculated as a percentage of commissions. They might not always be able to help the fund manager know how much research it actually consumed and evaluate its true price — if the research provider doesn’t give a dollars and cents figure. Ganatra says that Commcise’s commission management system incorporates a broker-vote application that allows the fund manager to do determine not only how much it spent on research for each fund but what it bought and evaluate its value.

The largest fund management firms might ultimately decide to pay for the research out of the management fees simply to avoid the stress of justifying the payment. Smaller-sized asset management shops who can’t afford to take the hit might either raise their management fee or follow the EC’s rules. “It’s a tough call because if fund managers decide to raise their management fees, they would have to explain the reason to their clients,” says Bollenbacher. “The funds themselves would then be put in a spot to decide whether they should agree to the higher management fee or rely on a more transparent research budget which would also require them to evaluate whether the research spending is valid.”

There will likely be different strokes for different folks. “A UCITS fund might follow what the fund manager decides and go with the higher management fee,” he says. “By contrast, a European pension plan or endowment would likely ask for CSAs to be used because they would have transparency in how research dollars are being spent and set up an up-front limit on their annual research expenditures for the year.”