Unforeseen Consequences

Rudolf Siebel, Managing Director of German Investment Funds Association BVI questions whether the FCAs recent CSA proposals will improve or harm continental asset managers’ service.

Rudolf SiebelThe Financial Conduct Authority’s (FCA) recent announcements about Commission Sharing Agreements (CSAs) affect asset managers on the continent just as much as their UK counterparts, according to German asset management association, BVI’s Rudolf Siebel.

Continental asset managers were surprised that the ESMA is addressing the subject of unbundling. Given that the Level 1 directive does not discuss research, but speaks in general terms about inducements, we were surprised by the direction the ESMA took. Our members are now investigating what is driving the FCA in this discussion.

We previously introduced a Code of Conduct which also covers soft commissions and research stating research must be used for the benefit of the client, e.g. the investment fund. However, the recent focus on unbundling urged us to send a letter to the FCA. It is not our policy to comment on a purely UK consultation, but because of its wider European reach and its possible impact on the discussion at ESMA level, we sent a letter.

The FCA is correct to improve the pricing of research, but better pricing can be developed in different ways. One way which has not been tried before is to set a dedicated budget for research to make this budget transparent. That would have the effect of formally adding pricing to research, requiring asset managers to scrutinize the implicit cost of research in the execution of fees. If asset managers disclose their research budgets, this would facilitate client scrutiny of that spend.

Beyond research pricing, the FCA identified certain problems such as the overconsumption of research but does not provide any evidence in this regard. The FCA also suggests the quality of research and trade execution is lower than expected. We believe that these alleged inefficiencies should be dealt with by regulation and in any case do not require the action proposed by the FCA. General pricing of research would help mitigate any inefficiencies.

Moreover, we strongly disagree with the claim asset managers are incentivized to trade excessively in order to receive more research, as it is described in Point 5-26. The claim that asset managers disregard the existing obligation to act in the client’s best interest is incorrect. Again, this allegation lacks any evidence. Further it contradicts the FCA’s claims that there is overconsumption and lack of quality of research. It is unlikely that asset managers would create an order to procure research if that research lacks quality. In that case, asset managers would just as soon order and pay separately for specific, recognized, high-quality research.

If the FCA’s proposals are implemented, there may be a number of negative consequences, as other industry bodies and buy-side firms have explained. The first is reduced research and decreased competition between research providers. The proposed rules would place asset managers under pressure to reduce their demand for research in order to balance costs. A reduced market for research would negatively affect competition between research providers, favouring market participants with larger trading books, who can cross-subsidise research.

It is unclear how independent research providers would benefit from such a situation. On the sell-side, smaller, independent researcher firms are likely to suffer, as would smaller asset managers that would find it financially difficult to build their own research departments.

There is a separate concern that small and medium-sized enterprises will receive less market coverage. Already, large research providers essentially focus more on large and medium caps instead of small and medium-sized caps because these entities are more important for trading. Many companies in the DAX 100, for example, could see reduced coverage, which obviously constrains their access to capital contrary to the intention of European and German politicians to provide more long-term financing for these entities. Finally, less exhaustive research inhibits the market’s effectiveness in pricing stocks and other securities.

If the FCA goes forward as proposed, it would exceed any ESMA rules. We hope that the FCA is not considering unilaterally requiring UK unbundling, but we recognise that they are promoting this option at European level. If these rules are tightened both in Europe and in the UK, the asset managers providing active portfolio management would have to re-price their services. This may nudge the market toward non-European managers both in North America as well as in Asia to offer their services cheaper and thereby gain a competitive advantage over European-based managers. We see no plans in the US, Hong Kong, Singapore or Australia to unbundle research and execution.

The potential competitive situation for European asset managers vis-a-vis their international counterparts is not just a theoretical exercise. Major non-European firms, such as Capital Group, Wellington Management, Fidelity and Pimco, are very active in Germany. For local managers, the competition is often on a basis point by basis point level, and if research would become more expensive, that could sway some of the mandates as a lot of German investors are very cost sensitive.

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