By Chris Halverson, CAPIS
Nearly four years ago, I penned an article examining the MiFID II mandate that EU firms unbundle payments for investment research from execution costs. In it, I made the case for why Section 28(e) of the Exchange Act, adopted by US lawmakers in 1975, plays a valuable role in helping asset managers acquire the research they need while lowering the total cost of trading.
I’ve never been one to say “I told you so” – so I won’t. But it certainly seems European regulators have concluded that our argument was correct. In a recent consultation paper, the UK’s FCA indicated it is prepared to scale back MiFID II restrictions on bundled research. The FCA was the biggest advocate of these restrictions while they were still being debated, and it seems likely that the EU’s ESMA, which has already rolled back research restrictions on fixed income and small caps, will follow suit.
We applaud the spirit of the EU’s efforts to foster more disclosure regarding research costs. But even something as fundamental and essential as transparency cannot exist in a vacuum – it is not immune to cost-benefit analysis. A 2023 study by Substantive Research found that buy-side research budgets had dropped by more than 50% since the introduction of MiFID II; in turn, the sell-side has slashed research headcount and reduced the amount of research that is available. Whatever economic benefits MiFID II brought by shining a light on research costs have been more than offset by reduced access to information and analysis that can lead to higher returns.
In the US, Section 28(e) and the Client Commission Arrangements (CCAs) it allows for have helped protect domestic firms from these trends – not completely, but meaningfully. These “safe harbor” provisions are nearly 50 years old, yet they reflect a timeless belief: that ensuring the creation of and access to investment research is of vital importance to serving investors. As European regulators are now demonstrating, this powerful concept is worth enshrining in law, even if the specific mechanisms may feel arcane at times.
The following paragraphs borrow heavily from the piece I wrote four years ago, but they bear repeating. If you’re looking for an explanation for why MiFID II has played out as it has, look no further than the tenets of Section 28(e).
Benefits of Section 28(e)
In large part, Section 28(e) was enacted to protect the practice of acquiring research in exchange for brokerage commissions. Section 28(e) created a safe harbor for investment managers to use client commissions to acquire “research and brokerage services.” In 2006, the SEC issued an interpretative release, which clarified the rules governing CCAs. The law hasn’t changed since.
While the type of research and brokerage services vary, they are all designed to enhance the investment decision-making process and improve execution quality, thus benefiting the end investor. Since its inception, Section 28(e) has been successful in helping asset managers acquire the research they need to enhance shareholder value. Some reasons for this success can be directly tied to the regulatory structure for acquiring research:
- Depth and Breadth of Research: Clients benefit when investment managers have access to a broad variety of research. Allowing research to be acquired with commissions helps the US lead the way. Brokers and third-party providers are incentivized to create valuable research supporting investment managers, both large and small. Lacking this mechanism would stifle innovation and competition, as only the largest firms can recreate this diversity of analysis.
- Research Innovation: It is not a coincidence that Bloomberg, FactSet and other popular research tools were all born in the US. The funding made possible by commissions has helped spur some of the most valuable and innovative research services in the world.
- Lower Barriers of Entry: With access to research supported by commission activity, barriers to entry are reduced for new managers and strategies.
- Access to Capital: Robust research coverage supports capital formation, enabling small companies to access public markets. Without ongoing research coverage, small firms would find it more difficult to garner interest and, by extension, make investments that support their long-term success.
Why Section 28(e) Works
By not altering the 2006 Interpretive Release in response to MiFID II, the SEC got it right. In doing so, they created a competitive advantage for US funds against their European counterparts. The safe harbor provisions of Section 28(e) benefit US-based asset managers, and their underlying investors, by:
- Enabling investment managers to compensate brokers for innovative research products that enhance internal efforts
- Spreading the benefit across all client accounts, which is far less burdensome than the exhaustive disclosure standards of MiFID II
- Helping small to mid-sized managers compete via lower barriers to entry
After a few years in the woods, it seems European regulators have come to agree – but damage has already been done. The studies on research creation, staffing, and fund performance highlighted at the beginning of this article speak for themselves. Restricting the research procurement process may have saved investors 1-2 bps in costs, but that’s a tiny fraction of what they lost in terms of performance. It’s the textbook definition of being penny wise and pound foolish.
While the terms may vary, CCAs/CSAs were designed to enhance the investment decision-making process and benefit the end investor through improved performance. Hats off to the SEC for recognizing the importance of our current market structure and not forcing unnecessary change on the US. Main Street returns are healthier as a result.
