The rules of research are changing (probably). Out with the MiFID II unbundling rules, in with the new

The report on the UK investment Research Review has been published and was covered in a speech by Chancellor the Exchequer, Jeremy Hunt. The key takeway is that changes are in the pipeline in relation to current MIFID research rules, and in particular, the research unbundling rules. This will be welcomed by some in the industry who question the usefulness of the research payment accounts and those who have questioned the benefits of the FCA's UK MiFID Quick Fix rules.

The future changes to UK MiFID sit alongside those that will be introduced as part of the Financial Services and Markets Act 2023.

What has happened?

On 10 July 2023, the Investment Research Review published a report, making a series of recommendations to the Government, the FCA and industry (the Kent report). On the same day, Jeremy Hunt delivered a speech at Mansion House, outlining measures for improving the functioning of capital markets and promoting growth-friendly regulation (see our briefing here). This follows a December 2022 announcement by the Chancellor, as part of the Edinburgh Reforms (see our briefing here), confirming that an independent review of financial services investment research and its contribution to the competitiveness of UK capital markets would be launched. Terms of reference and a call for evidence followed. The recommendations in the Kent report contain some significant proposals for investment service firms operating in the UK.

Why the need for action?

Firms providing investment research or non-independent research must comply with a number of FCA rules. In the past, UK regulators have allowed investment research to be paid for using bundled payments. However, MiFID II prohibited bundled payments in most situations.

Under the current UK rules, research can be received by portfolio managers from direct payments by the firm i.e. its P&L or from a separate "research payment account" (i.e. money agreed by way of annual budget with the portfolio/fund). These rules have been tweaked since 2018. For example, as part of so-called UK MiFID Quick Fix, the FCA relaxed rules in relation to issuers with a market capitalisation of below £200 million, as well as research on FICC instruments and research from independent research providers.

The Kent report notes that many feel that there has been a decline in investment coverage in the UK and that the pricing of research in the UK post-MiFID II is "broken". According to the report, some of this occurred before MiFID unbundling rules and could be due to: waning interest of institutional investors in equity markets investments; the reduction in commission rates for trades in UK equities; and a decline in secondary market trading in UK equities.

According to the Kent report, the MiFID II unbundling rules on the provision of research in the UK are generally perceived to have resulted in: significant changes to the compliance systems and procedures by buy-side asset managers regarding the consumption of research; reduction in the amount of money available to pay for research; and the reduction in number of providers from whom buy-side asset managers source external research. Furthermore, the reluctance of firms to amend complex pre-existing systems and renegotiate existing arrangements for what are perceived as piecemeal reforms are cited by the report as key reasons for the minimal impact of the UK MiFID Quick Fix.

What is being proposed in relation to research?

The Kent report identifies seven recommendations, but for investment firms the three key recommendations are perhaps: introducing a Research Platform to help generate research; allowing additional optionality for paying for investment research; and allowing greater access to investment research for retail investors.

What is the proposed so-called Research Platform about?

The Research Platform would allow for the centralised promotion, sourcing and dissemination of research on issuers (with a particular focus on smaller cap companies), with participation widened to include all UK publicly traded companies on all exchanges, as well as companies on intermittent trading venues (more of this below).

Under the proposals, the Research Platform would be operated centrally by one or more entities and the operator could be an exchange/other provider of market infrastructure appointed after a tender process. One of the interesting features of this is that research would be "freely available". The financing has to come from somewhere, and the report suggests a number of potential sources, the issuers, the exchanges, possibly Government (…), a stamp duty rebate via share purchase or a general levy on financial services firms.

What about the research bundling rules? It's back to the future.

The report recommends the removal of the restriction on combining the cost of research with execution charges, so that bundled payments become one of a range of options that is available (i.e. sell-side firms would not be required to facilitate payments on a bundled basis or be able to require that buy-side firms use bundled charge). Under the proposal, buy-side firms could pay for investment research: out of their own resources; by making a specific charge directly to their clients in respect of the costs of research; or by combining the cost of research with execution charge (on a disclosed basis – i.e. back to pre-MiFID equity CSA world).

Buy-side firms using investment research would be required to: allocate the costs of research fairly between their clients, whilst observing the requirement to treat their customers fairly; have an arrangement for the allocation of payments between the different research providers (e.g. commission sharing agreements); create and implement a formal policy concerning their approach to investment research and for its payment; periodically carry out benchmarking or price discovery on the research they use; and make appropriate disclosures to the client. Specific consent of the buy-side's underlying clients to these arrangements would not be mandatory (subject to any pre-existing contractual arrangements).

What else is being proposed?

The Chancellor's speech refers to the introduction of a new "Intermittent Trading Venue", a wholesale markets trading venue aiming to improve the access of smaller companies' access to markets. The idea is for this to be functional before the end of 2024.

How does this compare with what is going on outside of the UK?

The Kent report is keen to stress that current UK regulatory regime could mean UK firms are losing out, arguing that the UK should seek to remain aligned with other key jurisdictions, such as US and EU on research rules (where appropriate). It suggests that wider research coverage and greater research capabilities of US investment banks and brokers could be partly due to the adoption of the bundled model for the purchase investment research. It also argues that the expiration of US Securities Exchange Commission's no-action reliefs in relation to research payments may result in UK asset managers no longer being able to access some US research.

The report also states that the current UK regime could also impede UK buy-side firms' access to EU investment research in the future. As part of its 2021 Quick Fix regime, the EU introduced rules allowing firms to bundle costs for research and execution in relation to small and mid-cap issuers whose market capitalisation did not exceed EUR 1 billion. The European Commission published the so-called Listing Act in 2022, setting out a number of amendments to EU MiFID in relation to inducement rules (possible changes to the research unbundling rules). The report is therefore recommending a removal of any barriers preventing UK buy-side firms from paying for investment research in jurisdictions where payment on a bundled basis is normal practice.

What next?

The FCA released a statement confirming it would review the report and its recommendations, adding that it planned to engage with market participants and consult on potential regulatory changes concerning the purchase of investment research. The FCA also confirmed that it plans to make any relevant rules in H1 2024.