The UK's post-Brexit balancing act begins with MiFID II
The amendments represent the UK’s response to the EU’s “quick fix” package that was approved in March this year, which addressed these issues, amongst other things, for EU firms.
The UK’s approach essentially mirrors the objectives of the EU’s reforms, while seeking to address the perceived deficiencies in the EU’s rule changes. This appears to be the UK’s strategy vis-à-vis the EU regulatory regime, at least in the short to medium term: an attempt to retain broad equivalence in regulatory outcomes, but with an ambition to streamline or to improve specific rules.
Exempting investment research from inducement rules
MiFID II imposed requirements upon firms to set separate charges for transactions and research. Firms receiving research are required either to pay for research themselves from their own resources or to agree a separate research charge with their clients. The MiFID II requirements applied to research regardless of the market capitalisation and size of the firm. The EU’s quick fix has legislated to reverse parts of the “unbundling” rules, the rationale being that revising the rules might increase the availability of research in certain parts of the market and, as a result, the potential for increased investment.
The FCA are also proposing to loosen these requirements in different parts of the market where it is perceived that a “re-bundling” of the transaction charges and the research charges are low risk and might yield benefits to market participants. However, the FCA’s approach is more flexible and more limited in scope than the EU’s reforms.
The FCA's proposals in the consultation paper are summarised below.
- An exemption from the inducement rules for research on listed or unlisted SMEs companies who have a market capitalisation below £200m provided it is offered on a re-bundled basis or for free.
The exemption for SME companies has been proposed to increase research coverage particularly for smaller firms where levels of coverage are currently low. The FCA’s proposed approach differs from the EU’s reforms in three respects.
First, the EU’s re-bundling rules apply only to companies with a turnover of less than €1bn. The FCA suggest that a £200m threshold better targets SMEs companies where investment research coverage is at its poorest.
Second, the EU requires that the firm exercising the option to re-bundle payment must have both informed the client and have agreements in place identifying the part of the combined charges for research and execution services.
The EU’s quick fix package is also a temporary measure for a 12-month period. The FCA’s approach is not time limited and offers greater certainty as to the UK’s long-term view on payment for research.
By treating research under a low threshold as a minor non-monetary benefit, the UK has arguably proposed a logistically simpler approach than the EU’s reforms. Given the relatively large threshold for SMEs in the EU, many asset managers would be required to bifurcate payment for equity research within their business. There are complications, for instance in relation to cross-subsidies and sharing of research between different parts of the business. The optionality of the EU’s re-bundling, in addition to the complexity and the temporary nature of the rules, perhaps mean that few firms will choose to exercise the option.
Although simpler, it remains to be seen whether the UK’s approach might have its intended effect of increasing the availability of research about smaller companies. The FCA acknowledges that there might only be an incremental benefit and that additional measures might be necessary to support SMEs.
- An exemption from the inducement rules for receipt of third-party fixed income research.
These transactions are usually not paid for directly, and the broker earns revenue from the spread. Therefore, the FCA argues that there is less of a risk that transaction costs and the costs of research are opaque to investors when bundled than in equity research. Firms are expected to benefit from reduced compliance and administrative costs because of the exemption. The EU’s quick fix legislation likewise provided for re-bundling of fixed income research, albeit as a temporary measure that might be extended or made permanent.
- An exemption from the inducement rules for research received by independent research providers where this does not involve execution.
The FCA suggest that research in this context does not raise the same kind of conflicts that can arise with research produced by investment firms. Although only a small segment of the market, such boutique research houses provide an alternative source of research and therefore increase the availability of research generally or in niche segments of the market. Granting an exemption provides the market clarity that research providers that do not directly engage in trade execution, or that form part of a group engaged in execution and brokerage, are not captured by the unbundling rule.
- An exemption from the inducement rules for openly available written material.
The exemption for free research that is “openly available” (provided without restrictions such as a log-in) has been proposed in the hope that it can serve as an incentive for entities such as trading venues in the UK to provide research on this basis. This exemption arguably confirms an approach which was already being being applied in practice in the market.
This suite of exemptions is a clear attempt by the FCA to drive competitiveness and increase the availability of research in areas where they perceive that the risk of bundling research is low.
Best execution reporting
MiFID II’s Regulatory Technical Standard (RTS) 27 requires execution venues to publish quarterly metrics about the quality of trade execution at the level of individual financial instruments. RTS 28 requires executing firms to publish an annual report listing the top five execution venues and brokers where they have executed client orders in the preceding year, and a summary of the execution outcomes they have achieved. The FCA proposes removing these requirements. The justification provided by the FCA to remove these requirements is noteworthy:
We support the MiFID II objectives of increasing transparency and improving information about how firms execute and transmit their client orders and the outcomes that they obtain for their clients. However, we are concerned that RTS 27 and RTS 28 have not delivered on these objectives in a meaningful or effective way.
Many firms will welcome the UK’s determination given that the reports are often found to be burdensome and costly to produce. The consultation references evidence that few investors access the reports, while many wholesale investors require more detailed information for their purposes.
At first glance, the FCA’s stance appears to be a significant divergence from the EU position. However, ESMA set out in a publication last year that RTS 27 reports are “rarely read by investors, evidenced by very low numbers of downloads from their website” and the European Commission have implemented a two year suspension on the enforcement of RTS 27 reports in light of the pandemic. Despite EU firms’ dependence on execution venues’ RTS 27 reports to produce their RTS 28 reports, firms are still expected to submit RTS 28 reports this year. It is possible that the EU may address the inconsistency in the Commission’s broader review of the MiFID II legislation this year.
The deadline for feedback on the FCA’s consultation is 23 June 2021. The consultation forms the first part of the UK’s broader review of capital markets with a consultation from HM Treasury expected in the summer.
While it is unclear whether the UK will decide to diverge from other parts of MiFID II or from other parts of the EU’s capital markets framework, it is becoming clear that the UK will not simply adopt a “copy and paste” approach to new reforms from the EU. This is very significant given the ongoing pace of EU regulatory change.
The post-Brexit Memorandum of Understanding on Financial Services, published in March, did not yield any agreement on specific financial services regulations. If and until, the EU decides on equivalence and market access in certain areas, the UK appears likely to continue a balanced strategy.
If equivalence decisions are not forthcoming from the EU, the UK might seek to diverge more strongly from EU regulations. We have summarised some of the UK’s options, and their possible benefits and costs, in our ‘Big Bang 2.0’ report.