How a Quiet SEC Decision Created a Complex Research Payment Problem

The Securities and Exchange Commission is allowing a no-action letter related to MiFID II to expire in July 2023. While it sounds like a bureaucratic snafu — the letter allows European managers a workaround for some of the onerous regulations they face when dealing with U.S. brokers — the impact is much broader. 

The findings from a survey to be published on Wednesday shows just how concerned — and confused — asset managers are about the costs and effects of the SEC’s decision. Managers told research analytics firm Substantive Research that research payments estimated to be $100 million are at risk, and that the expiration of the no-action letter will spur consolidation in an already-consolidated industry. Third-party research providers — those not affiliated with behemoths like Goldman Sachs and Morgan Stanley — will likely bear the brunt, while the big firms will gain additional market share. Managers say they’ll lose more independent voices at a critical time in the markets. Substantive Research surveyed 40 managers, with a total of $6.5 trillion in assets. 

The SEC’s decision came out quietly and without warning. Mike Carrodus, CEO of Substantive Research, told II that those circumstances lead him to believe that the commission likely thinks asset managers and brokers can easily adapt to the changes. “But this isn’t going to be solved easily, and it’s a problem that didn’t have to happen,” Carrodus said. “The SEC could have just extended the letter like they did in 2019. A lot of people are asking why now? Especially with just a year to go.” 

The no-action letter solved a problem after European regulatory regime MiFID II, which became effective in January 2018, unbundled trading commissions and research bills. The new rules pushed European asset managers into paying for investment research in cash, a fundamental change to the market. At the time, the SEC issued a no-action letter that allowed European investment shops to also pay U.S. brokerage firms in cash. Although the letter was not intended to be a permanent solution to the different rules governing payment for research in Europe and the U.S., the SEC confirmed last month that it would not extend the letter past next July’s expiration date. (The commission extended it once in 2019.) As a result, European asset managers will need to pay for research from U.S. brokers through trading commissions, in line with their U.S. peers.

There are at least three potential workarounds suggested by firms, but according to Carrodus, “None of the solutions in their current forms work, and even if they did work, the key stakeholders in this market are extremely resistant to doing them.” 

One option is for brokers to become registered investment advisors. A number of brokers, including Bank of America and Jefferies, have already done this, allowing them to take payments directly. But, according to the survey, asset managers are split on whether this ultimately solves the challenges around paying for research. 

Twenty-nine percent of respondents expect large U.S. brokers that have not yet registered as RIAs to do so, while 32 percent said these firms won’t become RIAs. The rest of the respondents to the survey said they were unsure about brokers’ future strategy. 

It’s easy to understand the ambivalence that managers feel. First, “It’s not that easy to become an RIA. It takes time and the hoops are many,” said Carrodus. “If you’re an RIA, okay, [clients] can read the research, maybe they can still e-mail and talk to an analyst, but they certainly can’t get color from your sales and trading folks. So hang on, if I’m an asset manager with people in trading and investment professionals, the research product is all of that stuff to me. If you suddenly said, ‘You can read or send the odd question to an analyst, but that’s it,’ I’ll say, ‘Okay, I’ll pay half, then,’” he quipped. 

Asset managers can also create research payment accounts, or RPAs, which is the only way that they can generate research payments from trading commissions under MiFID II. Carrodus explained that this solution can link payments to trades, so funds can ultimately be reimbursed for the cost of the research, essential in today’s rocky markets. “But this is an incredibly complex solution, especially if you’re not very big.”

“So the broker-led solution: tricky. The asset management solution seems like no-go to me,” said Carrodus, adding that all respondents to the survey were against implementing such structures.

“The third option is to just pay London the whole lot,” he said. Big European asset managers or European divisions of U.S.-based firms could pay for everything out of an office in Europe. But there are a number of problems, including concerns by many of the biggest managers that they’ll be perceived as trying to get around the spirit of the regulations. “The bigger asset managers feel like that solution is dicey.” Even so, according to the survey, “60 percent of managers believe that the most likely outcome is that U.S. brokers with a global business will be paid entirely in Europe for research used by clients in both regions and covering both markets. Smaller U.S. brokers that don’t have a European presence will be frozen out.”

Almost 70 percent of managers think the SEC’s move will lead to more market concentration by the big brokers, a theme also uncovered by a Substantive Research survey completed in March 2022.

“This is another nail in the coffin of diversity in the research markets,” he said.