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​Why Research and Dealing Cost Unbundling is Dangerous for Small Firms

By Selin Bucak, 19 February 2015

Whenever new regulation is discussed, small and medium-sized firms are always the first to worry. Will they be able to carry the burden of costs? Is this change going to kill the SME industry?

This scenario is certainly under discussion following the European Securities and Market Authority’s (Esma) MiFID II proposals on dealing commissions and research costs. Under the proposals, asset managers will have to pay directly for research from broker firms so it cannot be considered an inducement. The use of dealing commission for research and access to analysts will therefore be banned when MiFID II is introduced in January 2017.

According to Ross Barrett, capital markets specialist at the Investment Association, smaller firms may be disadvantaged by the proportionate cost of buying in research.

However, Colin McLean, managing director at SVM Asset Management, said there is no reason the ruling on dealing commissions should be more of a burden to smaller firms. He calculates the combined cost for research and execution should not cost clients more than 20 basis points.

Following the Financial Conduct Authority’s (FCA) previous intervention in this area through the introduction of guidance to ensure clients are paying fairly for research, McLean said trading and research activity should be evidenced by performance. Contrary to some assumptions, he said this may be easier for boutiques to prove rather for than larger firms due to the amount of work involved. He expects fund groups to now look for a better deal by comparing brokers and cost.

Edward Williams, senior UK fund manager at Sanlam Four, said his company was still debating investment in new systems to accommodate unbundling. He does not expect this to have a substantial impact on the firm. ‘We only pay for top quality research anyway. We do a rifle shot approach to research rather than a shotgun approach,’ Williams said. He said although it would cost the firm in terms of potentially dampening profitability, it would not change the business itself.

Research by Numis Securities previously predicted that firms would suffer a 5% hit to profitability in 2014 and 2015. Meanwhile, Berenberg estimated a 20- 30% hit to industry profitability. Ian Sealey at Neptune Investment Management said his fırm has already established systems for research costs, stemming from the FCA consultation papers released in 2013: ‘We pay our brokers through a mixture of commission-share arrangement or bundle. We have a cap for it and set budgets for each one of our brokers. We’re looking across all of our brokers and how much we pay, pushing down broker commission in places we have been able to.’

Comply or die

Barrett says fund groups can either pay off their balance sheet or charge clients specific fees for research, which then goes into a research payment account (RPA).

If the firm pays for research out of its own money, the research budget can be spent however the firm chooses, he said. However, if firms want to charge clients, there needs to be more control.

‘If you want to charge the client, there are number of systems and controls requirements that are required to make sure one client isn’t disadvantaged. There would have to be controls. They will have to account for the money and to track disclosure to clients. ‘A lot of the controls being suggested will already be in place for many firms. It will be a question of enhancing those,’ he added. ‘This is the view we put to Esma. In the current proposal, they are going to require brokers to price their research as well. You have brokers having to price research and firms having to buy that research.’

He believes large firms should be able to adapt to this process, but notes there could also be less research generated, which could make it more expensive. Barrett said the cost of unbundling will also have VAT implications. While bundled research is currently VAT exempt, under Mifid II it will result in research losing that exemption. ‘The VAT exemption is only for brokerages. If firms are buying research from brokers they will have to pay VAT on that. That in itself will make it an unattractive option,’ he said.

‘We are helping our members in terms of the current proposals, and how they can comply with the conflict issues and the VAT question we’re following up with. ‘You charge a fee to the underlying client, whether that money is used for research – whether it is client money or the firm’s money – we need to investigate that as well. This will result in significant change if the proposal stays as it is.’

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