On 28 April, the UK's Financial Conduct Authority published consultative paper 21/9 in which it proposed to make changes to the British conduct-related and organisational rules that pertained to the European Union's Markets in Financial Instruments Directive or MiFID. In this paper, we examine the main proposals, the rationale behind them and the implications for investment firms.

The main proposals

The FCA proposes to exempt the following research services from the inducement rules in COBS 2.3A by treating them as “minor non-monetary benefits.”

• Research on listed and unlisted small and medium-sized enterprises with a market capitalisation below £200 million.
• Research focusing on fixed income, currency and commodity (FICC) investment strategies.
• Research from independent research providers who are unconnected, either directly or with other group entities, to execution or brokerage services.
• Written research that is openly available to other firms or to the general public.

The FCA proposes to drop the following disclosure requirements in respect of "best execution."

• The obligation for execution venues (including brokers) to provide quarterly metrics on execution quality (so-called RTS 27 reports).
• The obligation for investment firms that manage portfolios or that receive and transmit orders to produce annual reports about execution outcomes, including the top five execution venues used in each asset class (these are known as RTS 28 reports).

The whole story in a nutshell

The unbundling of commissions to pay for research and best execution was among the more radical measures that MiFID II introduced when it came into force throughout the EU at the beginning of 2018. As part of the process of leaving the EU, the UK has 'on-shored' all relevant legislation onto its own statute book, creating “UK MiFID.” This has left the kingdom with the option of reforming these rules to further its own objectives.

The EU has made its own changes to these rules in the form of a “quick fix,” itself a response to its Capital Markets Recovery Package to support economic recovery when the pandemic subsides. These changes consisted mainly of two measures: the re-bundling of commissions in relation to companies with a market capitalisation of less than €1 billion; and the suspension of RTS 27 reports for two years, starting at the end of February 2021.

The FCA’s current proposals should be seen in the context of both these developments.

Rationale for reform

Ironically, the FCA was one of the main proponents of the complete unbundling of commission payments in the run-up to MiFID II. Payment for research services since 2018 has generally been well received by buy-side firms in mainstream equity sectors, with effective costs falling (by some 20-30%) and much duplication of effort eliminated.

The case for unbundling FICC services was always less clear-cut, with many sectors embedding costs in dealing spreads rather than commissions. The benefits of sell-side analysis were not very obvious either.

The FCA’s arguments for re-thinking the rules about SME research are interesting, particularly in the context of its proposal of a lower threshold (£200 million instead of €1 billion). The regulator sees little evidence of a decline in research coverage for companies below the €1 billion mark since 2018. However, it has noted an absence of coverage, especially at the lower end of this spectrum.

MiFID II’s disclosure regime as it pertains to best execution probably promotes competition among execution venues and gives the end-users of financial products the information that they need to challenge execution results. The task of providing RTS 27 and 28 reports is onerous without any obvious benefit.

Regulatory divergence

Is this the start of regulatory divergence from the EU? There is probably not a simple answer at this stage. The FCA’s proposals are a clear response to the EU’s quick-fix package and may be seen as an attempt to stop Britain from ceding a significant competitive advantage to firms from the EU. At the same time, the proposals show that the FCA is willing to consider a rationalisation of the rules in accordance with the principles of high standards, with proportionality and with support for economic growth through open competition. The elimination of RTS 28 reports is proof that the FCA is prepared to go its own way.

Implications for firms and next steps

The FCA’s consultative exercise is open until 23 June and will be followed by a policy statement in the third quarter of the year which will contain the finalised rules. The proposals are relatively uncontroversial, so it seems likely that the FCA will carry them through more or less in their entirety. The EU’s quick-fix comes into force on 28 February 2022, so it seems reasonable to assume the FCA will want to mimic that.

Buy-side firms with SME, fixed income, commodity or macro strategies ought to start asking their counterparties how they wish to change their current arrangements. It seems unlikely that they will want to continue paying directly for macro or economic research (rates for these services have been low in any case), but sell-side firms may try to recoup these costs through dealing commissions or spreads once more.

Multi-national managers operating in the FICC space may also be able to unwind arcane arrangements for circumnavigating the rules for research in many jurisdictions at once.

Independent research providers will be freer to distribute their services in the larger company research sector and this will encourage them.

Few tears are likely to be shed for the end of the best-execution disclosures, but the exact timetable for halting these is not known. MiFID portfolio managers may hope to be relieved of their obligation to report RTS 28 for calendar year 2021 but ought to continue to record the relevant data for now.

* Martin Lovick can be reached on +44 20 7042 0500 or at martin.lovick@acacomplianceeurope.com