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MiFID II –Discussionpaper

September 2016

The future ofresearch

Impact of MiFID IIon research forinvestment firms

As part of the investor protection framework within MiFIDII, investment firms need to make explicit payments forinvestment research in order to demonstrate that they arenot being induced to trade. Investment firms will need tohave systems in place in order to manage unbundledpayments for execution and advisory services,develop a taxonomy of services that are categorised asresearch and pricing models for these services.

This regulatory obligation will pose significant challengesfor the industry as sell side firms must complete theseactivities and disclose the associated costs and charges tobuy-side firms in order for them to demonstrate that theyare acting in their best interests and have not been inducedto trade.

However, it also presents significant opportunities as theproduction and dissemination of research services mustnow be considered a distinct revenue stream that can besold to clients.

This paper sets out what the MiFID II requirements are,the challenges and practical implications associated withthese, what this will mean for the industry, and lastly howfirms can establish programmes and approaches such thatthey maximise any potential upside.

Executive summary

1 | The Future of Research | PwC

New requirements for research

MiFID II and what it means for research

MiFID II and MiFIR set out new requirements thatcontinue to reform the EU securities and derivativesmarkets by further enhancing what was introducedunder MiFID I in 2007. The legislation is due to go livein January 2018 and will introduce significant front toback changes for bond, stock, commodity, andderivative trading.

In addition to ensuring markets are operating in anorderly fashion, the new requirements seek to enhanceboth transparency and investor protection in order toprotect end investors. As part of this newrequirements are being introduced to mitigateconflicts of interest risks associated with research butalso to ensure research isn’t being offered as aninducement. The requirements fall on both buy andsell side investment firms and include:

• Sell side firms must not induce clients to trade bybundling research within their execution services.

• Sell side firms are required to review and identifyservices provided that could be categorised asresearch and therefore for which paymentwould be required.

• Sell side firms need to provide clients unbundledcosts of trading, separately identifying andcharging for execution, research and otheradvisory services.

• Buy side firms have to make explicit payments forresearch, and demonstrate that research contributesto better investment decisions and is therefore notan inducement.

• Investment firms need to provide better reportingto facilitate payments being made for researchand to help demonstrate the value that researchis providing.

We expect limited further guidance or detail will beoffered by ESMA or local regulators on the newrequirements for research prior to the nationaltranspositions, due in March 2017. However, to meetthe requirements by the MiFID II deadline of January2018, both buy and sell side firms must begin to actnow, perform their analysis using assumptions wherethere is uncertainty, and determine the most strategicand commercially viable means of operating in the postMiFID II era. As part of this, consideration should begiven to touch points and dependencies with the otherregulations being implemented across Europe (such asMarket Abuse Regulation), and what enhancementsneed to be made to the control environment to supportthe decisions being made.

This paper highlights some of the key challenges thatneed further thought and potential outcomes for theindustry as a consequence of the new requirements.

PwC | The Future of Research | 2

Defining which services should be categorised as research

MiFID II goes beyond the existing MiFID I or Conductof Business (COBs) definition of Investment Research.It no longer just applies to independent investmentresearch but it also applies to advisory services provided byFront Office Sales or Trading personnel. This extendeddefinition includes:

• Materials or services that could inform an investmentstrategy, adding value to an investment decision, eitherexplicitly or implicitly.

• Covers one or several financial instruments, issuers offinancial instruments, assets or related market sectors.

• Provides a substantiated opinion as to the present orfuture value of the given asset, instrument or issuer.

Buy and sell side firms will now need to create frameworksto evaluate the myriad of materials and services theyproduce, distribute and consume to understand whereon the spectrum it lies, and therefore whether it needs tobe paid for.

Spectrum between ‘Marketing’ and ‘Research’ MarketingResearch

Segregatedresearch team

• Behind ‘barriers’.

• Specific,conclusive tradeideas andcommentary.

• ‘Substantive’(COBS 11.6.5).

• Not behind‘barriers’.

• Conclusive tradeideas andcommentary.

• Not necessarily‘Substantive’(COBS 11.6.5).

• Ideas andcommentary.

• May be relatedto specificsecurities,sectors,industries,markets.

• Distributed onlyto clients.

• May contain arecommendedaction.

• Ideas andcommentary.

• May be relatedto specificsecurities,sectors,industries,markets(‘colour’).

• Distributed onlyto clients.

• Generally not arecommendationfor an action.

• Produced bymarketing staff(with internalassistance).

• Not arecommendationfor an action.

• Informationgenerallyfor publicconsumption.

Desk-basedresearch

Desk-basedtrade ideas

Commentary,morning notes

Advertising,marketing

Challenges and practical implications

For some materials, firms may be able to demonstrate that they are of a minornon-monetary benefit and therefore exempt from the new requirements providedthe service is not substantiated and nor does it contain any substantive analysis.However the majority of materials are unlikely to meet the criteria for theexemption and so will be defined as research meaning the investment firm will needto consider the impact on operating models, resourcing and pricing.

Classification is complicated further by the often unclear link between ‘research’ andthe ‘benefits’ clients derive from such ‘research’. Research producing firms must beprepared to judge this objectively going forward.


Paying for research

Historically when a buy side firm increased its tradingvolumes, it could pay more for receiving the sameamount of research and would pass on these costs to itsclients. With the new requirements buy side firms mustnot link the amount paid for research to the volume orvalue of transactions, instead they must agree a budgetto be paid for research up front and pay an amount thatcorrelates to the quality and value that it would provideto the end investor.

Buy side investment firms are able to make the choice ofpaying for investment research:

• Directly from their own account; or

• Should they choose to pay using client commissions,using a Research Payment Account (RPA) supportedby a Commission Sharing Agreement (CSA), whichcodifies how execution costs are split into executioncosts and research costs and how commissions are tobe shared amongst research providers.

Fund X

Sell side investment firm

Research payment account

Direct payment for research – Money from own account

CSA

Typical executioncomponent – ~30%

Typical researchcomponent – ~70%

Independentresearch providers

Buy sideinvestment firm

Firms must make explicitpayment for advisoryand execution services

Payments can bemade to third parties

To support this sell side investment firms willneed to unbundle their costs for research from thecost of execution, such that buy side firms can makeexplicit payments for research received. They willthen need to be able to process direct payments orcommission based payments and attribute thosepayments appropriately.

Regardless of the payment mechanism, sell sideinvestment firms will need to manage paymentsfrom clients, funds within clients and other researchproviders. This model may need to be flexible suchthat it can be optimised to be able to deal withdifferent regulatory environments.

Buy side firms will need to weigh up which of theoptions is more optimal. While paying directly mayminimise the operational impact of the newrequirements, profit margins will be impacted unlessmanagement fees can be increased. If managementfees are maintained then, ceterus paribus, this mayincrease the attractiveness of the fund manager to itsclients. On the other hand, if firms are seeking torecover costs using client commissions, there will be aneed to introduce or enhance existing RPAs and CSAs.This will have a greater operational impact and willrequire change to existing processes. Whicheveroption is selected, firms will need to demonstratethat research obtained does represent value for money.


How do you price research?

Sell side firms and independent research providers needto assess how best to price research. They can consider anumber of options each of which will have a differentoperational impact:

• Explicitly pricing into the bid offer spread or thecommission the cost of providing research and chargeuntil an agreed cap has been reached with each client.

• Charge clients a direct payment on a regular basis foradvisory services which would include chargesfor research.

• Charging specific amounts for bespoke and specificpieces or research.

For cash equities, implementing changes is likely to beeasier given the concept of unbundling is not new, butfor fixed income and other non-cash equity asset classesadditional thought is going to be required on how toderive a price that reflects the value that research brings,what its costs to produce, and the economic reality thatif research is over priced their clients will not be preparedto pay for it. This will require investment firms toundertake an analysis of its costs of producing servicescategorised as research, using this informationto determine a minimum price for which the researchcan be provided.

Whichever option is selected there will be technologychanges that will need to be implemented to supportthe decision.

Governance and control

Appropriate controls, senior management oversightand audit trails must exist to ensure the research budgetis being used in the client’s best interests, and whetherresearch is being classified correctly, regardless ofwhether the clients or the fund managers themselvesare funding the research. Key to this will be the needto create or enhance existing reporting to facilitatepayments, and allow both the buy and sell side tomonitor the quality of research using feedback provided

via mechanisms like broker voting, to help demonstrateand prove that research is not an inducement to trade. Ifinvestment firms do not already have these frameworks itmay introduce further operational burdens, require systembuilds and an added layer of administrative costs.

Additional organisational changes may be also requiredto manage potential conflicts of interest and ensure thereis an appropriate segregation between those that produceresearch that could be perceived to be independent, andthe Front Office. Although in many instances thissegregation may exist, it may require teams such as deskanalysts or strategists rethinking where organisationallythey should be aligned and whether that should orshouldn’t be behind a Chinese wall.

Technology impacts

The new regulations will require a number of changesto technology that investment firms operate including:

• The need to build or augment existing pricing and/orcommissions systems to provide enhanced reportingshowing unbundled costs (splitting advisory andexecution services) such that buy side firms candemonstrate that they have not been offeredinducements to trade.

• The need to build or augment systems such that thesell side can provide aggregate and cumulative costreporting to the buy side at least annually.

• Infrastructure will be required for sell side firms to beable to process direct and commission (i.e. bid-offer)based payments and to be able to monitorresearch payment accounts versus agreed budgets.

• The need to build or augment systems to meet theaffiliated requirements around disclosures of costsand charges which will allow investment firms todemonstrate that they are not being induced to tradeto the regulators and to their clients.


The new requirements will have far reaching implications on the industry

Industry implications

Implementation of the requirements will drive anincreasingly efficient market with more competitivelypriced, quality research. Buy side firms previouslyreceiving duplicitous, and/or low quality research, willbecome more particular about what they are receivingand who they are receiving it from as they will beexplicitly paying for it in order to demonstrate they arenot being induced. This could provide opportunity forindependent research firms to fill in the gaps where sellside firms are not able to deliver on either quality orprice, leading to a rise in the number of independentresearch providers and an increase in the number ofservices that sophisticated buy side firms bring in house.Possible implications include:

• Sell side research providers ranked between 1 and 5 intheir respective sectors. It is likely that research fromthe large sell side firms with highly rated analysts willcontinue to be valued and sought after by the buy side.If these research providers transition successfully, theywill be in a position to commoditise and monetise theirresearch offerings.

• Sell side research providers ranked between 6 and 20in their respective sectors. The mid-tier researchproviders may be those that are impacted the hardestby the MiFID II requirements. These firms couldstruggle to charge for research unless they innovateand find ways in which to differentiate their researchor ensure high levels of value and quality are provided.For these firms, decisions to continue to providea research service to clients will require a detailedcost-benefit assessment.

• Specialist or niche research providers. These willconsist of either smaller, boutique sell sideinstitutions, or independent niche research houseswho produce specialist research that the larger firmsfind uneconomical to produce or for which they do nothave the expertise. Due to the exclusivity of theirmaterials and services, these firms are likely tomaintain or increase their market share, as buy sidefirms are likely to value their services, and as somemid tier firms are pressured out of the market.

• The changes to inducement rules and potentialunbundling of research payments creates thepossibility of more VAT becoming due on chargesgoing forward, and increased costs. The VATtreatment is not confirmed and there are complexitieswhich are being explored both by individualbusinesses and also at industry forum level.

• The number of funds being sold by the buy side. Giventhe explicit costs associated with buying research, buyside firms maybe reluctant to pay for research, whichin turn may impact their ability to build up sufficientmarket knowledge and expertise to set up anddistribute new funds in asset classes currentlyunfamiliar to them. This in turn may have theimpact of reducing the number of new fundscoming to market.

• Research aggregators. It is likely that these firmsincrease in number or grow in size, as the buy sidelook to simplify how they acquire research, and as thesmaller niche providers look for more attractive andexpansive ways to distribute their material.

A potential unintended side effect on the industry couldbe the reduction of good quality research for the smallerand mid tier stocks. This could be both because mid tierfirms stop producing research, but also because the buyside, who now need to demonstrate value for researchbeing paid for, are less prepared to explicitly makepayments for the analysis. This in turn may reduce theliquidity of these markets and lead to a widening ofspreads for certain products. This is contrary to theintention of the regulators, who were seeking totighten spreads with MiFID II to provide better valueto end investors.


How we can help

Any impact on operating models and profit marginsfor investment firms will be dependent on how theychoose to approach the challenges described in thispaper. Firms that are willing to consider the longterm, strategic view and evaluate the implications ofMiFID II across their entire front to back operations,their client base and their product and serviceofferings will be better able to position themselvesoptimally in areas where their capabilities andresources allow them to use the regulations tobuild a competitive advantage. Specifically PwCcan help through:

• Categorisation of services that areconsidered research.

• Review your organisational structure, developtarget operating models and provideregulatory guidance.

• Help your firm to understand their cost base andso develop their pricing models.

• Review systems architectures to ensure thatyou are able to provide clients with thepayments management and meet theirdisclosure requirements.

• Develop a supervisory framework,governance structures and provide assurancepost implementation.

• Provide industry expertise so that your firm is notapproaching the solution unilaterally.

PwC have helped a number of firms develop theirMIFD II programmes and specifically support themwith strategic decisions around the researchchallenges they face. This has been donecollaboratively, considering both the businessstrategy and the competitor environment. We havehelped investment firms how to categorise servicesthat maybe considered research, provided advice onthe drafting of new CSA’s, defined requirementsfor system and supporting client portals, and set outnew frameworks and operating models.

Building an approach to MiFID II

If you would like more information or support on:

Andrea WintermantelPartner, Banking and Capital Markets

M: +44(0) 7733 333944E: [email protected]

Amee AujlaDirector, Banking and Capital Markets


Fiona LehaneDirector, Insurance and Asset Management


Elliot HandManager, Banking and Capital Markets



This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the informationcontained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy orcompleteness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents donot accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the informationcontained in this publication or for any decision based on it.

© 2016 PricewaterhouseCoopers LLP. All rights reserved. In this document, “PwC” refers to the UK member firm, and may sometimes refer to the PwC network. Eachmember firm is a separate legal entity. Please see www.pwc.com/structure for further details.

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