By Xi Yu, Compliance Consultant
The Investment Research Review (IRR), published in July 2023, examines levels of financial services investment research in the UK and how this has contributed to UK capital markets competitiveness. Ultimately, it seeks to bridge the gap between UK and US markets and renew interest in small and mid-cap UK equities.
One of the systemic – and perhaps unintended – consequences of MiFID entering into force has been the conflict between regulations regarding research payments.
It used to be that investment research was funded by trading commissions paid by asset managers who then expensed these costs to their end investors. The prohibition of inducements under MiFID required broker-dealers to charge research costs separately from execution fees, thereby ‘unbundling’ the former packaged structure.
This has created a gap between asset managers subject to MiFID in the EU or the UK versus brokers based in the US – a gap that the IRR aims to remediate. In this article, we’ll detail the outcomes of the review and the potential solutions identified.
The IRR’s findings
Chapter 4 of the IRR highlights the following points of interest surrounding the UK investment research market:
- Overall, the availability of investment research in the UK is comparable with other global financial centres. However, a commonly held view (albeit not without dissent) is that the UK is “perhaps no longer as pre-eminent” as a location for research as it was a decade ago. It is worth noting that the IRR specifically compares the UK investment research market with that of the US, where greater coverage of public markets is available both in terms of breadth and depth
- Analyst coverage is responsive to the nature of the companies publicly traded in a specific market. For instance, technology companies are better covered by analysts in the US and certain Asian markets. However, the IRR notes that a number of respondents to the government’s Call for Evidence expressed concern about a perceived lack of expert investment analysis. Notably, the market has witnessed over the last few years a “juniorisation” trend whereby investment research was usually undertaken by more junior staff with fewer resources, thus potentially impairing the quality of research
- Investment research in the UK is marked by a significant disparity in coverage between companies with capitalisation in excess of £1bn (larger-cap) and smaller-cap companies, the latter being under-researched. This links back to the growing concerns raised by the government regarding the quality and quantity of research available for high-growth sectors such as life sciences
- The unbundling requirement prescribed by MiFID has undoubtedly had an adverse effect on the availability of investment research. The IRR questions whether this set-off effectively enabled EU and UK markets to enhance fee transparency as initially intended. Under MiFID, asset managers must fund research either from their own funds or via a separately held research payment account (RPA). The IRR notes that buy-side firms rarely use RPAs due to their complexity (e.g. client communication, annual budget review, periodic qualitative assessment). Simultaneously, a number of asset managers have simply reduced the amount they spend on research to decrease expenses, instead focusing on integrating research capabilities in-house. Nevertheless, the IRR rightfully points out that institutional investors had been moving away from UK equities and secondary trading as part of their risk-averse strategy before MiFID was enacted
The IRR’s recommendations
Based on its findings, the IRR issued seven recommendations to help foster and develop the UK market as a centre of excellence for investment research:
1. Introducing a research platform to enhance coverage and availability
2. Allowing optional payments for additional research
3. Granting retail investors access to investment research
4. Involving academia and bursaries to boost research
5. Supporting issuer-sponsored research by establishing a code of conduct
6. Clarifying aspects of the UK investment research regulatory regime
7. Reviewing the investment research rules in the context of IPOs
The merits of a rebundling exercise
A key recommendation supported by the IRR is the rebundling of research expenses with trading commissions by providing flexibility on research analysis covering smaller and mid-cap companies.
It was previously suggested to amend Article 24 of MiFID so that a “safe harbour” for investment research fees be included in the definition of “acceptable minor non-monetary benefits”.
In the EU, as of February 2021, firms were able to bundle research and execution costs for research relating to small and mid-cap issuers, subject to a market capitalisation ceiling of €1bn. This quick-fix measure, established by Directive 2021/338 to cope with the depression caused by COVID-19, was welcomed by market participants.
The following year, the FCA broadened the outer boundary of “acceptable minor non-monetary benefits” under UK MiFID to include research relating to (a) issuers with a capitalisation below £200m, (b) fixed income, currencies and commodities instruments, and (c) research produced by independent providers. Note that the capitalisation ceiling in the UK remains significantly lower than that which is currently implemented in the EU.
Despite the FCA’s attempt to deregulate research fees, this safe harbour primarily relies on statutory interpretation, which leaves buy-side firms in a state of uncertainty until a higher court settles on the matter. To overcome this legal void, the IRR goes further by recommending that an express statutory exemption be established to allow asset managers to rebundle investment research while still requiring the former to disclose the portion of fees spent on research outputs. This would fill in the existing gap between MiFID and the Advisers Act.
Although the IRR was generally well received by both the government and the industry, several market participants have already questioned the merits of a rebundling exercise in light of the extensive operational and compliance costs that buy-side firms had already incurred to comply with MiFID when it originally entered into effect.
In the aftermath of the IRR, the FCA issued a press release, committing to take “swift actions” to engage with market participants by the end of H1 2024. However, we note that wider regulatory changes proposed by the review – such as a potential amendment to FSMA and the RAO may only be actioned by HM Treasury.
Across the English Channel, the European Commission introduced a proposal to amend EU MiFID on 8 December 2022. The proposal, which forms part of the EU Listing Act bill, seeks to increase the existing threshold from €1bn to €10bn in an effort to facilitate research coverage and foster the EU’s attractiveness to potential investors. The Listing Act is currently being negotiated between the Council and the European Parliament.
Despite this regulatory saga, research continues to be a significant industry in its own right. In 2022, investment analysis of global cash equities generated a global revenue of approximately $11bn, with Europe and the UK making up roughly $3bn of the aggregate figure.
In our view, rebundling research costs could be part of the solution for renewing global interest in small and mid-cap UK equities. However, it is unlikely that asset managers will be switching their post-MiFID research process before any definitive reforms are promulgated. In the meantime, the FCA is expected to begin a public consultation later this year.
