Once again, MiFID II is at the regulatory forefront. Late last month, the European Commission proposed changes to help their capital markets weather COVID-19 and curb the regulations’ unintended consequences.
Designed to address various conflicts of interest and improve transparency in European markets, MiFID II was implemented in 2018. One of the key provisions was the unbundling of payment for investment research from execution costs.
While these changes directly impacted EU nations, the SEC opted not to alter U.S. regulations in response to MiFID II. The “safe harbor” provisions of Section 28(e), implemented in 1975, remain the law of the land. With that said, MiFID II has had an impact on U.S. markets. It has shined a light on how much buy-side firms pay for research, and more importantly, the impact of research on returns. Over the past two years, it is clear that investment managers subject to MiFID II have trimmed their research budgets dramatically. In 2019, the FCA reported that research budgets had fallen, on average, 20-30%.
As a result, the sell-side has adjusted, trimming staff and reducing the amount of research that is available, a trend compounded by related pressure on independent research providers.
While CAPIS applauds European regulators’ efforts to enhance transparency regarding the use of client commissions, we are not surprised by the unintended consequences. Small companies, research providers, and investment managers have all paid a price. The question seems to be, “Was it worth it?” The short answer is no.
From our perspective, the SEC should be lauded for leaving U.S. regulations alone. There are meaningful benefits surrounding the practice of acquiring research with commissions under Section 28(e). Supplementing internal research efforts leads to higher returns. Protecting the mechanism that supports it is paramount. The SEC acknowledged this as far back as 1972. In its Statement on the Future Structure of the Securities Markets, the SEC stated “it is…essential that…the viability of the process by which research is produced and disseminated not be impaired.” Those words still hold true today.
In the U.S., Client Commission Arrangements (CCAs) provide a framework for separating the costs of research and execution in a bundled commission. It provides clarity without limiting asset managers as to how they acquire valuable investment research.
Benefits of Section 28(e)
In large part, Section 28(e) was enacted in 1975 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. U.S. 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 U.S. 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 U.S. 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, allowing small companies to access public markets. Without ongoing research coverage, small firms would find it more difficult to garner interest, and therefore, make investments that support their long-term success.
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 U.S. funds against their European counterparts. The safe harbor provisions of Section 28(e) benefit U.S.-based asset managers, and their underlying investors, by:
- Enabling investment managers to compensate brokers for innovative research products
- Enhancing internal efforts
- Spreading the benefit across all client accounts
- Less burdensome than the MiFID approach
- Helping small to mid-sized managers compete
CAPIS feels the “forced unbundling” and restrictive regulations associated with MiFID II have crippled the research ecosystem in Europe and have had a negative impact on fund performance, as evidenced by the recent study from Evercore ISI/Frost Consulting.
Restricting the research procurement process may have saved investors 1-2 bps in costs, however, those savings pale in comparison to the 100s of basis points in lost performance. It’s the textbook definition of being “penny wise and pound foolish.”
While the terms may vary, CSAs/CCAs 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 U.S. financial services industry. Main Street returns are healthier as a result.