By Jeffrey O. Himstreet, corporate counsel, PGIM fixed income law, PGIM Fixed Income
(Editor’s Note: This is Part II of a three-part part series. To read Part I click here. Check back next week for part III or sign up for our news alerts to stay informed.)
Transparency to Clients. The “unbundling” of research expenses from transaction costs is certainly an issue that has garnered its share of industry press. Ten-plus years in the making, the EU approach to banning what in the US is referred to as “soft dollars,” may be ending. Sell-side firms have long sent fixed income managers research of varying degrees of quality and varying degrees of specificity. Fixed income managers rely on at least some of this research for investment ideas, credit analyses, and related information. MiFID II requires this research to now be paid for – by someone – rather than subsidized through execution costs paid by the manager to the sell-side dealer.
Managers thus have a choice – they can pay for the research themselves, have their clients pay for it (which carries its own compliance obligations and risks, discussed below), or “just say no.”
Some materials received from sell-side firms are general market commentary and not fairly described as “research” – so-called “minor non-monetary benefits” — can continue to be received gratis from the dealer. Information that is anything more – i.e., materials that provide substantive direction must be purchased.
If clients are to pay for the research, then MiFID II requires that firms place client-subsidized research dollars into a designated account and that the manager 
develop and implement controls reasonably designed to safeguard those client research dollars.
As fiduciaries, advisers also must assure that the research paid for by Client A is not inappropriately benefitting other clients and that Client A’s is receiving the benefit of the research it is underwriting and that the sell-side firms are charging the manager (on behalf of its clients) a fair price for the research.
In addition to the compliance and operational risk associated with such safeguards, it will be necessary for managers seeking to have clients pay for the research to discuss with clients the need to set up a research payment account, and obtain necessary client authorization to open and fund the account. The processes and controls required around the use of a research payment account may for some firms prove to be just enough rope with which to hang oneself.
The other option for managers is to pay for the research themselves.
Managers will (and are presently) inventorying the materials they receive and deciding what (a) constitutes research under MiFID II and (b) research for the manager is willing to buy. Sell-side firms are developing a myriad of payment options for research – sell-side firms appear to be settling on a cafeteria-style usage fee for research, a subscription model, or a hybrid of the two pricing schemes.
Managers paying for research themselves will have an obligation to make sure that they are receiving research under the most economically favorable terms under the circumstances. It has been reported that Vanguard will be paying an additional $100 million for research per-year, out-of-pocket.
Either option involves the manager developing procedures, controls, and disclosure to comply with the conditions imposed by MiFID II and assure that clients fully understand how managers use research and pay for it.
Fixed income managers are already facing very real fee pressure in the form of passive management and, more recently, algorithmic trading.
Only time can reveal whether the additional margin pressures brought by paying for research will force advisory fees higher, and what the overall effect that MiFID II will have on liquidity when considering research unbundling, trade reporting, and, as will be discussed in Part 3 of this regulatory update, best execution and record-keeping (including tape recording) requirements.
Be sure to check back next week for the last part of this series.
To meet Jeff Himstreet and learn more about this subject, please attend FTF’s Navigating the Maze of MiFID II conference, September 18 in New York.
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