Wall Street Braces for the End of Research “Free Pass”
US banks and brokers with European clients are bracing for the end of a five-year waiver by regulators on the requirement that research providers be registered as investment advisers. The waiver, which protected US financial institutions from domestic regulatory enforcement, will expire on 3 July. The requirement stems from the European Union’s Markets in Financial Instruments Directive (MiFID II), which separated payment for research from negotiation costs.
Complicated Compliance Ahead for Wall Street
Brokers serving European clients fear that registration as investment advisers will complicate trading compliance requirements. A partner at legal and business advisers Morgan Lewis, Steve Stone, observed that in preparation for the deadline, some Wall Street companies are scrambling to adapt to the U.S. Investment Advisers registration act. Stone added that brokers must expect increased regulatory costs associated with the European directive. Securities and Exchange Commission Chairman Gary Gensler told reporters last week that the industry should not expect relief from compliance with MiFID II.
Different Stages of Preparation
Beyond the new reporting requirements, US banks and brokers are grappling with complex changes to their structures, including unbundling research from commerce. However, there is no standard approach, given that company set-ups, preferences, and objectives vary. Some companies have opted to create European registered entities to solicit research fees, while still others simply want clear direction and proper compensation for their work.
Mixed Perspectives on MiFID II
Adapting to the MiFID II will affect investors differently. Among accounting professionals, there are those pushing for compliance, while others provide support for traders who may have lacked effective compliance procedures. At the same time, however, some observers see opportunity in research unbundling to promote transparency and assist smaller investors. The US Congress also took up the issue of the US “free pass” and agreed to a six-month delay in the lead-up to the deadline.
Summary
The Markets in Financial Instruments Directive (MiFID II) has required financial institutions operating in European Union territory to separate payment for research from costs associated with negotiations since 2018. US regulators provided a free pass on such requirements for US investment advisers dealing with Europe clients, but that entitlement expired on 3 July. The end of the five-year reprieve has created complications as US institutions scramble to adapt their structures to comply with MiFID II. Most institutions fear that meeting MiFID II compliance requirements could be costly and could force changes in current operational structures. But even as they prepare to comply, industry stakeholders, investors, traders, and accounting professionals hold different views on the efficacy of MiFID II in promoting transparency in research and finance.
How MiFID II Will Change EU and US Markets
Markets in Financial Instruments Directive II has brought a sweeping change to brokerage business in the EU. Since the directive’s introduction in 2018, research institutions and clients have been required to separate payment for research from negotiation costs and other expenses, such as industry conferences. According to the directive’s proponents, unbundling deters overly close relationships between brokers and fund managers that could obscure clients’ costs and services. Since direct payment requirements for research were introduced, British investors’ research budgets declined by 30% and more than half under the French estimates. However, the effect of MiFID II on coverage is unclear, according to the European Securities and Markets Authority’s 2022 report. Though the directive was greeted with relief in Europe, the opposite has occurred in the United States, as many firms have only just begun to grapple with the end of their “free pass.”
MiFID II’s Effect on Foreign Companies in the United States
Typically, US regulators are strict with non-US companies, and they have long been complaining about American lawmakers’ extraterritorial reach in developing rules and guiding compliance in industries such as tech, finance, and energy. However, in a variation to the trope of foreign companies forced to adapt to US regulations, MiFID II has US institutions conforming to EU rules. European companies doing business in the US have faced similar challenges before, as earnings from their American operations became subject to federal taxations under US rules. The jurisdictional limitations and consequences of MiFID II remain uncertain, and this uncertainty creates unease for companies doing business in Europe.
MiFID II Adoption and Compliance Challenges
The goal of separating research expenses from negotiation expenditures to make costs more transparent was the primary objective of MiFID II for EU regulators. However, securing compliance from financial institutions managing European investments has met many unique difficulties due to the complexity of brokerage business and the multiple channels through which payments are received. Some critics have expressed concerns that separating costs may negatively affect research quality, as institutional research departments may decrease in size. Ultimately, the regulatory changes exposed market and trading problems that can only be addressed through systemic overhauls of existing brokerage practices.
The Future of MiFID II and Research Unbundling
Investment opportunities have shifted since the onset of MiFID II, giving mid-sized investors the chance to buy research directly and have the freedom to take advantage of relatively low trading costs. Critics say that unbundled research management will hurt smaller firms that can neither afford the cost nor have enough research coverage. Nonetheless, MiFID II has become a permanent fixture of the financial industry, with its policy of separating research management expenses from trading appointments continuing to promote transparency in research. MiFID II remains a crucial directive for regulators and investors in both Europe and the US, and a comprehensive overhaul of the brokerage system led by financial authority is necessary to keep pace with the dynamic and complex economic landscape.
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Banks and corporations around the world have long complained about the extraterritorial reach of US regulation, which they are forced to adopt rules made in Washington. Now Wall Street is playing the injured party.
Next month, US banks and brokers with European clients are scrambling to cope with the loss of a US ‘free pass’ that protected them from the domestic regulatory effects of complying with EU rules on how their research is paid for by clients .
The so-called Mifid II rules were introduced by the EU in 2018, bringing about a fundamental change in the way the brokerage business works. In the United States, payment for research services – written reports but also matters such as industry conferences and access to corporate executives – is typically matched with negotiation costs. Clients “pay” for research by directing trades and associated commissions through selected brokers.
This was also the case in Europe, until 2018, before the Markets in Financial Instruments Directive separated the two and forced investors to pay directly for research. The goal was to end what some feared were overly intimate relationships between banks and fund managers that obscured the costs and exact services paid by end clients.
One of Wall Street’s major problems with the split is long-standing US law that requires any party that sells research to register as an investment adviser, which brings about a whole set of additional rules. Now, a five-year waiver by US regulators protects banks from being required to do so it’s about to run out. At best, AI registration is a complicated process. At worst, it will affect other investment banking operations.
Securities and Exchange Commission Chairman Gary Gensler told reporters this week that the industry should not expect a reprieve. Few expected it, but there is no single path for brokers to follow if they want to avoid investment advisor registration.
“Scrambling is a good word. Companies are in very different stages of preparation,” said Steve Stone, a partner at Morgan Lewis who is advising several clients on the effects of the waiver deadline.
Gensler’s energetic agenda often makes him the villain for Wall Street executives, but in this case the SEC can point to the fact that it gave the industry notice a year ago. Also, it’s not a mess of his creation, but caused by a change in EU rules. Nor are banks united on how to handle these issues: both Bank of America and Jefferies registered units as investment advisers when MiFID II took effect, showing that it can be done without limiting investment banking activities.
For brokers, however, rearranging complex structures just to fit a foreign rule is frustrating when none of the businesses they’re already overseeing are changing. “Registering as an AI won’t offer investors any additional protection – these are already highly regulated companies,” said one person involved in the industry discussion.
No two banks are set up in exactly the same way. Some have highly regarded trading desk analysts whose work doesn’t fit the traditional research model. Others fear that some client trades could fail in a US advisory bar on any proprietary trading. The consultants say some have European units through which they may be able to charge customers. Others, however, may have to interrupt some clients.
Investors are also mixed. Unbundling advocates see an opportunity to separate commerce from research in the United States as well, a cause they have championed since the 70s — because it would make costs more transparent. It could also help mid-sized investors who will never be the best clients for the likes of Goldman Sachs, but who would like to buy its research directly while trading with a smaller broker for whom they’d be a bigger fish. Others, after adapting to Mifid in 2018, simply want to know where to send their checks after 3 July.
In a twist to keep the matter fresh, the US House Financial Services Committee passed a bipartisan bill last month that would extend the waiver for six months and force the SEC to review the matter, examining the impact of Mifid on the US market. While it’s unlikely to become law before the deadline, it could still do so in the coming months.
US industry association Sifma had repeatedly asked the SEC to extend its waiver and pointed to European proposals that would allow for a “bundling” due to the belief that having fewer analysts selling research has hurt smaller companies. European investors have cut research budgets in the wake of MiFID, by 30%, according to British sumsand more than half, up French estimates. Yet a ESA 2022 document found the effect of Mifid on coverage was “inconclusive, unclear or difficult to isolate”.
There is an obvious irony in Wall Street’s grievances about extraterritoriality. But like European banks doing business in the US, there’s little choice.
jennifer.hughes@ft.com
https://www.ft.com/content/b5bee977-ba6d-4b12-90a0-1451ff4d5d1f
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