First published on Tabb Forum in May 2021

Faster than anyone anticipated, the FCA issued a consultation on the 28th April as part of its work with HM Treasury on capital markets reform and the competitiveness of the UK financial sector. The consultation includes significant changes to MiFID II research unbundling rules with the FCA going further than the EU in proposing changes to address some of the unintended consequences of MiFID II.

Europe’s response to unintended consequences

Over the last year, there was a view amongst EU politicians that Covid had exacerbated MiFID II’s unintended consequences for European asset managers, and that the research unbundling rules needed softening as part of a Covid relief package. In late 2020 the focus from them seemed to be on addressing risks to SME coverage as well as creating a carve-out for fixed income research.

Meanwhile, many industry participants were also arguing that MiFID II had made it very hard for niche, independent providers to compete with large banks and brokers.  This was because large banks and brokers were prepared to subsidise their research departments in a way that independent providers couldn’t, so suddenly independent research became expensive in comparison. This was hurting diversity and competition in the market  

The market also queried why fixed income research was included in these rules, when that market doesn’t behave at all like equities. The argument was that there was  nothing to ‘unbundle’, as research was not included in the spread.  The evidence of this came when research was unbundled in 2018 and spreads didn’t narrow as a result – inducements surely didn’t apply here.  

This European FICC carve-out would have been extremely welcome, but didn’t make the final cut in late 2020, whilst the SME carve-out, which was far less compelling to research consumers, did make it into the relief package. As SMEs represent a small part of asset managers’ research needs, many reasoned that they would only save a small amount of money, outweighed by the complexity and cost of administering a separate process. The market’s concerns about the damage to competition and independent research were not addressed at all. 

Addressing the real pain points

In this latest consultation, the FCA is specifically targeting the issues with independent research and FICC research and it’s great to see that the FCA has listened to the industry’s real pain points and is responding to the actual issues asset managers are facing regarding the unbundling regulations. 

The FCA is proposing  3 areas of change with regard to the MiFID II unbundling rules:

1 – FICC carve-out: inducement rules for fixed income research would no longer apply

2 – Independent research carve-out: Independent research would be exempt from inducement rules, which means that onerous controls around trialling these niche providers would no longer apply 

3 – Carve-out for research covering SMEs with a market cap up to £200m.

The fixed income and independent research carve-outs will have positive benefits for the investment research industry. It was hard to understand how FICC research could be “unbundled” and now, these budgets can be re-directed by asset managers to high focus areas, such as ESG or alternative data. At the same time, it makes sense for independent research providers to be exempt from inducement rules as they do not have a brokerage arm and cannot induce anyone to trade. The independent research carve-out has a direct, beneficial impact on the ability of larger firms to discover and trial independent providers without onerous compliance controls, stimulating competition and greater diversity in research supply.

With regards to the FCA’s SME carve-out, we do not expect this to materially change conditions for SME coverage. Much like the EU SME carve-out, the benefits of rebundling this research are outweighed by the operational complexity of creating another process for what is, in practical terms, a small part of asset managers’ research supply.

Essentially, the FCA has moved ahead with changes that will be welcomed by the asset management industry, and whilst doing so, has underlined its commitment to research unbundling and the benefits they have observed as having “brought improvements to the benefit of the end-investor. They are paying lower charges and receiving better quality execution services.”. 

The FCA consultation closes 23 June 2021. 

Asset managers based in the UK will now have to address how they plan to benefit from these changes and how to adapt their research valuation, budgeting and consumption approaches accordingly. Meanwhile, global and Continental European peers will be keen for the European regulators to follow suit, and it will be interesting to see how this plays out later this year.