Research re-bundling: Transparency and challenges in investment research

The financial industry relies heavily on research to make informed investment decisions. Traditionally, research costs were bundled with execution services so that investors paid a single fee covering both analysis of potential investments and carrying out trades. However, the introduction of MiFID II (Markets in Financial Instruments Directive II) in the European Union in 2018 brought about a significant change: research unbundling.

What is research unbundling?

Research unbundling separates the cost of research from the cost of execution services, meaning that investment firms must now explicitly pay for research, either directly out of their own pocket or through a separate research payment account (RPA) funded by client fees. This increased transparency aims to address concerns about potential conflicts of interest and ensure investors understand exactly what they’re paying for.

The rationale behind MiFID II unbundling rules

Prior to MiFID II, research costs were often unclear. Investors might not have known how much of their fees were going towards research, and the quality of research could be swayed by an investment bank’s desire to win the business. Unbundling seeks to enhance transparency by allowing investors to clearly see the breakdown of fees and make informed decisions about research providers. It aims to reduce conflicts of interest by separating research from execution, providing less incentive for research analysts to prioritize recommendations that benefit a bank’s trading desks. Unbundling also looks to incentivize research providers to focus on high-quality, independent analysis to justify their fees directly to investors.

The impact of unbundling

The introduction of research unbundling has had a multifaceted impact on the financial industry. Investment firms are now more diligent in evaluating the value of research before paying for it, which can lead to a more selective approach and potentially lower research budgets. The traditional model where research was bundled with execution gave significant power to large investment banks. Unbundling empowers investors to choose their research providers based on quality and value.

With a focus on directly charging investors, independent research firms might find a more prominent space in the market if they can deliver high-quality, unbiased analysis. Concerns exist that unbundling could lead to a reduction in research coverage, particularly for smaller and less liquid companies. This could limit investment opportunities for some investors.

Challenges and debates

While research unbundling presents potential benefits, it also faces ongoing challenges. Independent research providers may struggle to compete with large banks’ resources and the viability of such research depends heavily on investor willingness to pay for it.

Investors might have to pay more for in-depth analysis, potentially impacting smaller firms. If investors prioritize lower research costs over quality, it could negatively impact independent research firms. Striking a balance between transparency, research quality, and affordability remains crucial.

Return to bundled costs?

The UK Financial Conduct Authority (FCA) published a consultation paper in April 2024 outlining new proposals regarding re-bundling options for research payments. The final rules are expected in the first half of the year, subject to industry feedback and potential adjustments.

The FCA isn’t planning a return to the pre-MiFID II bundled model entirely. Instead, it is proposing a reform that offers more flexibility in how asset managers pay for investment research.

The proposals would allow asset managers to again bundle the cost of third-party research with execution charges but this would be optional, existing alongside current methods like paying from their own resources or a dedicated research payment account (RPA).

This flexibility aims to give asset managers more options for research procurement, meaning they can choose the most cost-effective and suitable method based on their needs. Potentially, this could lead to increased competition among research providers.

The FCA acknowledges the potential risks of conflicts of interest returning with bundling. It proposes implementing safeguards to ensure that asset managers maintain appropriate budgets for research spending, that costs are fairly allocated to clients who benefit from the research and that clients are informed about the research costs they incur. It also wants managers to properly assess the value of research before purchasing it and that costs are benchmarked to ensure competitiveness.

Overall, the FCA’s plan isn’t a complete reversal of unbundling. It’s more about offering asset managers additional options while keeping safeguards in place to mitigate potential risks.

Benefits and concerns of re-bundling

A major benefit of the new proposals is that the FCA aims for compatibility with research payment rules in other jurisdictions, potentially simplifying cross-border research purchases.

Asset managers, particularly smaller firms, might benefit from potentially lower research costs if bundled with execution and it could simplify some administrative processes.

Critics of the new proposals worry that bundling could incentivize research analysts to prioritize recommendations that benefit trading desks, potentially compromising research quality. If cost becomes the primary factor, research quality might suffer as investors prioritize lower fees over in-depth analysis and independent research providers might struggle to compete with bundled offerings from larger banks.

Ongoing efforts, long-term impact

Research unbundling represented a significant shift in the financial industry, aiming to promote transparency and potentially enhance research quality, through:

• Separation of research and execution costs: Brokers must clearly separate the cost of research from execution services (like trading commissions). This allows investment firms to assess research value independently.
• Payment options for research: Investment firms have two options for paying for research: From their own resources, or from a dedicated RPA funded by client fees, with clear transparency on these fees.
• Applicability: Primarily applies to investment firms providing portfolio management services in the EU.
• Impact on research providers: Aims to improve the quality and independence of research by making investment firms value it more.

However, navigating the challenges and ensuring a sustainable research landscape requires ongoing efforts from regulators, investment firms, and research providers alike.

The FCA’s proposed reform in research payment represents a potential shift in the post-MiFID II landscape. Whether it increases flexibility and improves efficiency for asset managers while maintaining research quality remains to be seen. The final rules and their implementation will be crucial in determining the long-term impact on the financial industry.