UK FCA adopts commission sharing arrangement-style investment research payment option

The UK Financial Conduct Authority (FCA) has finalised its plans for a new way to pay for investment research, which aims to give UK buy-side firms greater control over how they can purchase investment research.

The policy, which is similar to commission sharing arrangements (CSAs), permits the "bundling" of payments for third-party research and execution services, provided certain safeguards are in place, such as budgeting, valuation and client disclosure requirements.

CSAs enable asset managers to compensate a broker-dealer for trade execution while allocating a portion of the commission for research, which can then be used to purchase research from another broker-dealer or investment research provider – and is akin to "soft dollars".

The previous policy

The UK regime previously reflected the position under the EU's MiFID (Markets in Financial Instruments Directive) II legislation, which required that investment firms pay separately for research and other services. Firms had to either charge clients transparently via a dedicated research payment account (RPA) or pay for research themselves.

This "unbundling" rule, introduced in 2018 and backed by the UK authorities, was intended to provide more transparency for investors and reduce the potential for conflicts of interest where investment firms offer both execution and research services.

The rule aimed to address issues such as undisciplined spending on duplicative or poor-quality research, the inappropriate influence of research procurement considerations on trade allocation decisions, and the lack of transparency for investors around charging structures. In 2019, had "improved asset managers’ accountability over costs, saving millions for investors".

Issues with unbundling

The FCA's 2019 review and analysis found budgets set by firms for research had fallen by 20-30%, as firms cut the amount of research they procured in order to reduce spending. Critiques of the rule argued that it favoured larger asset managers, as unbundling made it harder for independent brokers to compete with the larger investment banks, and many smaller brokers were forced to cull their research teams or merge with rivals.

Unbundling has mostly led to asset managers paying upfront for the cost of research from their own resources, rather than charging clients separately. Using RPAs to charge research costs to clients is operationally complex and resource intensive. However, it is mainly smaller firms that use this option, and they may be less able to go down the alternative route of paying for research from their own resources. This situation arguably created barriers to new market entrants and disadvantaged smaller firms, harming competition.

Moreover, the FCA concluded that restricting firms to these payment options could have negative effects on UK asset managers’ ability to purchase research across jurisdictions, bringing significant and potentially disproportionate operational and regulatory complexities which could hamper global competition.

As part of the Edinburgh reforms to drive growth and international competitiveness in financial services, the government requested an independent review of the investment research market. In July 2023, the review team published the Investment Research Review (IRR), setting out a series of recommendations to improve the investment research market – its second recommendation was to allow additional optionality for paying for investment research.

A post-unbundling world?

The new rules allow firms to bundle payments for third-party research and trade execution (subject to certain "guardrails") and would exist alongside the other available options already permitted (paying out of own resources or using RPAs).

The greater freedom in how to pay for research should suit firms of varying business models and sizes and will hopefully address some of the competition barriers arising from the MiFID II's restrictions. For instance, the CSA option should suit firms whose clients refuse to pay for research as a separate charge but are open to soft-dollar or CSA arrangements.

The EU is also introducing changes to the MiFID II unbundling rules to offer firms greater flexibility on how to pay for investment research services. The FCA's new rules are designed, where possible, to align with regimes in other jurisdictions, including the EU, aiming to facilitate asset managers accessing research globally.

Under the new rules, firms can now pay for research jointly with execution services provided the firm:

• Has a written policy describing its approach to joint payments.
• Has established arrangements that stipulate the methodology for calculating and separately identifying the cost of research.
• Has in place a structure for the allocation of payments between research providers;
• Sets an annual budget for purchasing research using joint payments.
• Allocates the costs of research purchased through joint payments fairly between clients;
• Undertakes a periodic (at least annually) assessment of the value, quality, use and contribution to investment decision-making of the research purchased and ensures that any research charges are reasonable compared to comparable services.
• Discloses to clients on the firm’s approach to joint payments, including for instance if and how joint payments are combined with any other payment option, the most significant research services purchased, and costs incurred.

The rules also confirm that research services are not a factor in assessing "best execution" – and the rules for best execution continue to apply unchanged.

The EU is also making changes to the MiFID II unbundling rules to offer firms greater flexibility on how to pay for investment research services – this introduces a new payment option, alongside a number of requirements that an investment firm will have to comply with if they wish to bundle research payments with execution. The FCA's new rules are designed where possible to align with regimes in other jurisdictions, including the EU, aiming to facilitate asset managers accessing research globally.

Osborne Clarke comment

It will be interesting to see what impact the FCA's new CSA option has on investment research and on what timescale. For example, small brokerages and banks may have already disbanded their research departments in the wake of the MiFID II unbundling rule, so it is possible any changes may take a while to manifest. The new rules also retain levels of operational complexity that firms familiar with RPAs will recognise, which could be a barrier to their take up.

It is worth remembering that, far from being an example of post-Brexit divergence, the new changes are necessary to ensure the UK remains aligned with other key jurisdictions; in particular, the U.S. and the EU.

Moreover, the reforms around bundled payments are only part of the bigger picture. The IRR made six other recommendations to protect and develop the UK as a centre of excellence for investment research, many of which are much broader-ranging and trickier to implement than bundling payments. For example, its first recommendation involves the creation of a central facility or "research platform" to encourage and facilitate the promotion, sourcing and sharing of research, something the report acknowledges would be a significant innovation requiring adequate and sustained funding. The authorities' ability and appetite to act on these wider recommendations, and the impact this would have, remains to be seen.

The IRR is itself just one element of the government's drive to bolster UK capital markets, which also includes changes to the listing and secondary capital raising regimes. The FCA's updated listing rules, which recently came into effect on 29 July, aim to simplify and modernise the UK listing regime. These changes are intended to align the UK's regime better with international market standards, and foster growth and innovation in the UK stock markets. Most market participants are likely to welcome these updates.

Firms who may take up the new payment option from 1 August 2024 onwards, must ensure they comply with the FCA requirements and update their internal procedures.