Re-bundling payments for investment research

On 10 April 2024, the FCA opened a consultation on new proposals to revise the UK regime governing ways in which buy-side firms purchase investment research. The central proposal is the re-introduction of a payment bundling option, alongside a series of 'guardrails' intended to avoid or mitigate potential harms.

The consultation closes on 5 June 2024, and builds upon the Government-commissioned UK Investment Research Review led by Rachel Kent, which was launched as part of the Edinburgh Reforms and published in July last year. The FCA has indicated that it intends, if it chooses to proceed with its proposed changes, to publish a final policy statement within the 'first half' of 2024.

Payment bundling – the background

"Payment bundling" refers to practices by which buy-side firms, such as asset managers, pay for investment research provided by sell-side firms which provide both trade execution services and investment research products. The amounts due in respect of the trade execution and the investment research to be provided are 'bundled' together into a single payment.

Payment bundling was historically allowed in the UK. However, the FCA (and other regulators) had been concerned for some time about the effect of the practice on the market as a whole. These concerns included lack of transparency in respect of the cost of transactions, as well as possible conflicts between a buy-side firm's own interests and that of its clients.

Current prohibition on bundling payments for investment research

Bundled payments were progressively restricted in the UK over the course of approximately a decade up until 2018, when the revised EU Directive on Markets in Financial Instruments ("MiFID II") entered into force and, among other things, completely prohibited payment bundling for investment research.

How UK firms can currently pay for investment research

There are currently, in the UK, two means by which buy-side firms may purchase investment research, whether purchasing from brokerages which also offer trade execution services, or from Independent Research Providers ("IRPs") that offer research services and products only.

Firms may choose to pay for research out of their own resources, such that the cost of purchasing the research shows as a cost in the firm's overall profit and loss statement – the so-called "P&L" option. Alternatively, firms may pay to purchase research out of funds contained within a "Research Payment Account", which is funded in turn by research charges levied individually and separately on each of the firm's clients – the "RPA" option.

The FCA's research has indicated that uptake of the RPA option across buy-side firms as a whole has been very limited since its introduction, and that where it has been taken up, this has been disproportionately by smaller firms.

It is suggested that this is reflective of the substantial administrative burden involved in using the RPA option, as well as the fact that larger firms tend to have greater in-house research capacity, with a commensurately lower requirement to purchase external research. This, alongside simple resource disparity, has meant that larger firms have overall found it easier to pursue the P&L option, and to absorb the cost of purchasing external research from their own resources, than have smaller firms.

The FCA's analysis of the effects of the prohibition since introduction

The FCA expresses concerns in its consultation document that the prohibition on payment bundling may, since its introduction, have favoured larger firms on both the buy- and sell-sides.

On the buy-side, payment bundling allows small firms to incur research expense in a manner proportionate to the number of transactions they handle for clients. In the absence of a payment bundling option, the development of in-house research capability represents a substantial, and less scalable, set-up cost.

Meanwhile, purchasing external research from the firm's own resources is often unviable for smaller firms, and pursuing the RPA option – passing the cost of research on to clients – places small firms at a competitive disadvantage as against larger firms, which are better equipped to absorb research costs such that they do not need to pass these on to the client.

On the sell-side, the FCA has expressed concern that overall reduced demand for research, lower budgets for purchasing research on the part of buy-side firms, and overall low pricing for research – resulting from the prohibition on payment bundling – have advantaged large brokerages which also offer research services, who are better-equipped to treat research as a "loss leader" item subsidised by other business, and to take advantage of economies of scale.

The FCA's consultation also expresses concern about the global competitiveness of UK asset managers and the UK market as a whole, if those asset managers are constrained from accessing and purchasing research from as wide a range of sources as their international competitors. Particularly noted is the fact that a previous no-action letter issued by the United States Securities and Exchange Commission ("SEC"), which permitted US broker-dealer firms to accept separate, non-bundled payments for research and trade execution from buy-side firms located in MiFID jurisdictions, without having to register as investment advisers, expired in July 2023. This poses a problem for UK buy-side firms who are seeking to purchase research from broker-dealers in the US but are unable to make a 'bundled' payment to that broker-dealer to do so – and potentially disadvantages those UK firms in the global context.

Proposals for a new payment method

The FCA is proposing to bring in a new option by which UK buy-side firms can pay for investment research, which will permit bundled payments for research alongside trade execution services.

The proposals incorporate a series of 'guardrails' which are intended to prevent or mitigate the potential negative impacts which led originally to the introduction of the prohibition on bundled payments.

These include:

• The firm in question adopting a formal policy on bundled payments;
• Firms entering into agreements with research providers on how the separated cost of research will be identified – with the aim of promoting price transparency and impeding the potential growth of 'opaque' charging structures;
• Firms adopting a structure for allocating payments between research providers, with the objective of maintaining competition in the investment research market;
• Adoption of procedures for administering accounts used to purchase research (but not including requirements analogous to the existing 'RPA' payment option, which required monies to be periodically 'swept' into a firm-controlled account);
• An at-least-annually-reviewed budget for third-party research;
• Adoption of a consistent and fair approach for the allocation, as between the firm's clients, of costs associated with the purchase of research through bundled payments – ensuring that the costs incurred by any given individual client correspond with the benefit received by that client from the research purchased;
• Periodic assessment of the value of the research purchased in terms of its contribution to investment decision-making and its overall quality; and
• Disclosure to clients in respect of the firm's use of bundled payments to purchase third-party investment research.

A handful of further amendments to existing rules are proposed to complement the new payment option.

Authors

- Christophe Boucherie
- Poppie Bouch
- Doug Henderson