On 10 April 2024, the Financial Conduct Authority (FCA) published a consultation paper (CP 24/7) on Payment Optionality for Investment Research (the Consultation Paper). The Consultation Paper introduces the option for UK firms to pay for third-party investment research and execution services through joint (or ‘bundled’) payments provided certain requirements are met.
The Consultation Paper arises from the ‘Edinburgh Reforms’ announced by the Chancellor in December 2022, which aim to drive growth and competitiveness in the UK financial services sector. As part of these reforms, the Chancellor requested an independent review of the investment research market. In July 2023, an independent panel published the Investment Research Review (the IRR), which set out a series of recommendations to improve the investment research market. The Consultation Paper is a direct response to the second recommendation in the IRR to provide additional optionality regarding payment for research in order to permit UK asset managers to pay for research and execution on a bundled basis, as well as out of their own resources or by specific client charges. To prevent the UK from being at a competitive disadvantage, the IRR also included recommendations for the UK to align with other key jurisdictions, such as the EU and the US.
The Consultation Paper is open until 5 June 2024. Depending on the level of feedback it receives, the FCA aims to publish rules or guidance containing any required updates in a Policy Statement in the first half of 2024.
Background to proposals
MiFID II introduced requirements to separate (or ‘unbundle’) charges for execution from research services. Under UK rules implementing MiFID II, the receipt of third-party research by a firm providing investment or ancillary services to clients is generally considered an inducement, unless the firm pays for it from its own resources (the P&L Model), or agrees a research charge with each client to be paid from a separate research payment account (Research Payment Account or RPA Model).
Although the policy objectives of the MiFID II unbundling regime were to manage conflicts of interests and improve price transparency for both research and execution services, the FCA (in light of the IRR) recognises in the Consultation Paper that this regime has had an adverse impact on the provision of investment research in the UK, which may have negatively impacted the depth of the capital market and access to funding for UK companies. Ultimately this could impact the prospects for UK economic growth.
Certain changes to the MiFID II derived rules were introduced in the UK in 2022 to address some of these concerns, including the broadening of the list of acceptable ‘minor non-monetary benefits’ to include research on issuers with a market capitalisation below £200m so that they would not be subject to the inducement rules. However, the FCA has noted that very few firms made use of this change to pay for research on a bundled basis, with industry engagement suggesting that making operational adjustments for a small group of issuers may not be efficient.
More broadly, RPAs have proven to be operationally complex and resource-intensive. Large asset managers have chosen to pay for research out of their own resources through the P&L Model, or to enhance their in-house research capabilities. It is primarily smaller firms that use the RPA Model, as such firms are less able to pay for research from their own resources. This has created a potential barrier to new entrants into the asset management market, and potentially disadvantaged smaller firms and harmed competition in the sector.
In addition, UK firms face difficulty in paying for investment research in other jurisdictions where bundled payments are standard practice. This is particularly an issue in the US, where broker-dealers are not permitted to accept discrete payments for research unless they are registered as investment advisers. Although the SEC had provided relief for US broker-dealers in the form of a no-action letter enabling them to accept unbundled payments, this relief expired in July 2023.
Proposal to create additional payment optionality
In light of the concerns summarised above, the FCA is now proposing to permit UK firms to make joint payments for third-party research and execution services, subject to complying with a number of specific requirements.
The proposed requirements for joint payments include the following:
- Formal policy: firms will need a formal policy describing their approach to joint payments for research, including with regards to governance, decision-making and controls, and how these are maintained separately from those for trade execution.
- Written agreement: firms will have to enter into written agreements with research and execution service providers, establishing a methodology for how research costs will be calculated and separately identified.
- Operational procedures: firms will have to put in place operational procedures for the administration of accounts to purchase research. This will include periodic reconciliation and reporting for such accounts.
- Payment allocation structure: firms will have to put in place a structure for the allocation of payments across research providers.
- Budget for the purchase of research: firms will have to set a budget for the purchase of research based on the expected amount needed for third-party research, which must be reviewed at least annually. The budget should not be linked to the expected volumes or values of transactions executed on behalf of clients.
- Allocation of costs across clients: firms will have to set out an approach to the fair allocation of research costs across their clients.
- Ongoing assessments of research value and price: firms will have to periodically, and at least annually, assess the value, quality and use of research and undertake benchmarking of prices paid for research services.
- Disclosure to clients: firms will have to disclose to clients their approach to joint payments, their most significant research providers and costs incurred.
To ensure that the benefits of the current regime are preserved, the FCA has also proposed to confirm that research services must not be treated as a factor in assessing best execution, so that the best execution requirements will continue to apply unchanged.
The new payment option would be introduced by amending rules 2.3A and 2.3B of the FCA’s Conduct of Business sourcebook (COBS) and would sit alongside the existing P&L and the RPA Models.
Finally, the Consultation Paper is proposing the following changes to the list of minor non-monetary benefits in COBS 2.3A:
- Adding short-term trading commentary and advice linked to trade execution to the list of acceptable non-monetary benefits. This is aimed at ensuring that the new payment optionality does not create unintended differences, to the detriment of the existing RPA and P&L Models, in access to research from US broker-dealers (which may not be able to receive unbundled payments) and US investment advisers (which are able to receive them).
- Deleting the option for bundled payment to purchase research on companies with market capitalisations below £200 million. This deletion has been proposed as a result of the limited use of this acceptable minor non-monetary benefit under the current regime to enable payment for research on a bundled basis, combined with the proposal that the new option for bundled payments would be applicable to research on companies of any size.
Whilst the proposals are intended to be more operationally efficient than RPAs, market participants may raise concerns relating to the detailed nature of the requirements that have been proposed, in light of any operational practicalities and difficulties they may entail. It would need to be carefully considered whether the level of specificity may limit the extent to which the bundled payment option is likely to be used in practice. These concerns will need to be carefully balanced against the FCA’s aim of ensuring an appropriate degree of protection for consumers, including with respect to fair allocation of costs, value assessments and cost transparency, but also taking into account the benefits that may be achieved by providing a workable solution that may help strengthen the UK investment research market.
International consistency
The FCA has noted the need to balance a number of considerations, including the facilitation of the international competitiveness of UK asset managers. This includes an assessment of the alignment of the new payment option with similar rules in other jurisdictions.
In particular, the changes proposed in the Consultation Paper share certain features in common with recent legislative developments in the EU. The EU is introducing adjustments to MiFID II to likewise permit the bundling of payments subject to certain requirements. Unlike the FCA’s proposals, however, the EU changes do not set out any requirements with respect to establishing a budget for third-party research, an approach to cost-allocation across clients or a structure for payment-allocation across research providers. This is therefore another area where we may see some regulatory divergence between the UK and the EU, with the additional complexities that this will entail for firms that operate across multiple jurisdictions.
