The UK Financial Conduct Authority (FCA) has been in a pugnacious frame of mind lately. Its AMMS review published in November 2016 was a stern warning to active managers, criticising their fee structures and return generation in comparison to cheaper passive alternatives. On March, 3, 2017, the FCA issued a robust indictment of commission dealing arrangements, based on a sample study of asset managers.
Four years have elapsed since the UK financial services regulator published its “Dear CEO” letter, and over two years have passed since the FCA outlined changes to COBS 11.6 covering the use of dealing commissions. These changes required asset managers to minimise customer charges via commission payments, and prevent firms from obtaining non-eligible goods and services from sell-side brokers in exchange for client dealing commissions.
Despite this, the FCA believes the majority of asset managers in its study have fallen short of expectations. In a strongly worded statement, the FCA said firms had not met its standards in a number of areas including verifying whether research goods or services are substantive; attributing a price or cost to substantive research if they receive it in exchange for dealing commissions, and recording their assessments to demonstrate they are meeting COBS 11.6.3R, and not spending excessive client money.
“We expect to see clearly documented evidence to support the acquisition of permitted goods and services. In subsequent reviews we will also seek confirmation of boards demanding satisfactory management information on the subject. Firms are required to have adequate systems and record keeping processes,” read the statement.
The FCA also said that many firms were unable to demonstrate meaningful improvements to their processes. In extremis, the FCA said a handful of firms were still deploying dealing commissions to purchase non-permissible items like corporate access and market data services.
“The majority of firms continued to treat the receipt of corporate access from brokers as a free provision. Where these firms also operated limited controls and record-keeping over research expenditure, this leaves them exposed to the risk that corporate access or other non-permissible services might still influence the allocation of dealing commission expenditure. Some firms failed to record details of corporate access meetings and in some cases, had to rely on estimates when responding to our questions,” it read.
The FCA warned that continued breaches would be met with regulatory intervention. A failure to act could result in serious reputational damage for impacted managers. The FCA also criticised the research budgeting process at asset managers, citing firms with an absence of a research budget process had research spending levels closely correlated with trading volumes.
Nonetheless, the FCA acknowledged improvements had been made with 79% of organisations in the regulator’s sample using research budgets compared to 34% in 2012. A failure to budget researching spend properly can lead to wastage, and may result in firms being in breach of FCA rules requiring organisations to act in the best interests of their customers. “Greater scrutiny around budgetary requirements, including a comprehensive approach to valuing research, could result in lower costs and/or a more efficient use of dealing commission. This in turn may lead to better returns for investors,” read the FCA statement.
The FCA did have praise for firms where thoughtful research budgeting was implemented, with some organisations benchmarking their spend against external sources to validate value for money. Other firms, added the FCA, switched to execution-only arrangements once their periodic research budgets hit a certain threshold.
A handful of firms cover the cost of externally produced research from their own resources as opposed to using dealing commissions. The FCA said this reduces conflicts of interest, and enhances transparency about the charges clients pay. Such a policy also helps ensure best execution, while research will only be purchased if warranted. This means firms will buy better albeit less research.
Smaller firms are naturally concerned by the likely added research costs, not to mention the provisions outlined in the Markets in Financial Instruments Directive II (MiFID II). Asset managers have a fiduciary duty to work in the best interests of clients, but if firms are unable to afford quality research, it could deter them from executing certain trades. This would potentially undermine performance and investor returns.