CSA Unbundling: Not the disaster firms expect
Following the adoption of the Markets in Financial Instruments Directive (MiFID II) within the European Union, which is slated to go into effect beginning in January 2017, broker dealers are already speculating about the implications of unbundling research and execution costs. While the regulations are designed to increase transparency by requiring research, execution and other services to be charged separately, critics fear that the requirements could all but eliminate commission sharing agreements (CSAs).
It is unlikely but not impossible that the U.S. will go beyond its traditional CSA safe harbors and follow the EU’s more stringent regulations. However, many broker dealers’ fears are overstated, and a stateside unbundling of research and execution fees is unlikely to spell the doom of CSAs. In fact, the consequences would likely catch many broker dealers by surprise.
Execution Costs & Demand for Research
Many firms prematurely leap to assume that MiFID II regulations in the U.S. would translate into dramatically higher execution costs. The ever-increasing competitiveness of commission rates over the last decade has made it all but impossible for firms to raise their execution rates. Research fees could bleed into execution fees, but only if overall demand for research were dampened.
Contrary to popular belief, unbundling research and execution fees is unlikely to divert demand for research to increased interest in ETFs. Some clients may pursue exchange-traded funds as a means to reduce spend, but the need for research won’t evaporate. Instead, firms would need to modify their internal research processes to better predict spend for the next year. Complicated by rapid economic and political developments, accurate spend projections would likely require software innovation and investment to reduce the gap between projected and actual spend.
Challenges Across the Board
It’s often held that larger firms are better equipped to handle regulatory shifts, encouraging consolidation after major regulatory changes. However, were MiFID II-style regulations to be adopted in the U.S., it’s unlikely that large organizations would enjoy advantages over their smaller counterparts. Separating and disclosing research dollar amounts for every client account becomes exponentially more difficult for large firms, and even negotiating an approved research spend per account could be a massive undertaking. Meanwhile, smaller firms have smaller account rosters to manage, but are also less able to afford large expenses for back-office technology.
The EU’s impending regulations unbundling execution and research fees are unlikely to make their way to the U.S. in the near future, but broker dealers should be aware of potential impacts if the SEC does decide to follow suit. With downward pressure on execution fees combined with the continuing need for quality research, regulations fashioned after MiFID II are likely to drive technological spend and internal process reorganization. Regardless of regulatory requirements, broker dealers should ensure their firms have the tools they need to provide client-side transparency into execution and research costs.