Trade Ideas and MiFID II Q&A24th January 2018
With MiFID II now in force, we provide answers to some common questions about the effect of the Directive on trade ideas. As background, trade ideas are not directly discussed in the Directive, but most firms in the TIM network that have considered the question agree on the effect of the Directive on trade ideas. Our answers reflect what we understand to be the consensus in the TIM community. There are some buy-side and sell-side firms that deviate from the consensus and we highlight this where relevant. Of course we may have interpreted the consensus incorrectly. Please treat this Q&A as informational only as it is not intended to provide tax, legal, or investment advice. Independent professional advice should be sought before acting on any information in this Q&A. If you feel we have any of this wrong, please do let us know by writing to us at TIMfirstname.lastname@example.org
Does MiFID II affect my trade ideas program?
This depends on two main factors: is your fund caught by MiFID and how you currently manage your trade ideas program.
Firstly, not all clients are affected by MiFID II. If a buy-side is not active in Europe (eg trades out of the US), is a sovereign fund or a family office, the client may be unaffected by MiFID II. If you fall outside MiFID II rules you are bound by your local regulatory regime. So for example, a US buy-side that wants to pay European broker’s for their ideas with trading flow is free to do so, (and the European broker is free to receive that reward for its trade ideas). While AIFMs (Alternative Investment Fund Managers) are regulated under a different set of regulations, the FCA clarified in its June 2017 policy statement that AIFMs are included in MiFID II unbundling rules. Other European jurisdictions may not include AIFMs in MiFID II unbundling.
If you are caught by MiFID, then your must pay for ideas transparently – see below.
Can I reward brokers for their trade ideas from client funds, or must I pay directly from P&L?
The consensus view is that trade ideas can be paid for from client funds. This was true before MiFID II when many clients paid for trade ideas from Commission Sharing Accounts (CSAs). The consensus is that this remains true now as trade ideas continue to pass the ESMA tests for “Substantive Research.” While the Directive and various clarifying texts do not specifically confirm this consensus, a verbal public statement by the FCA in November added weight to this view. Of course, clients must pay from a Research Payment Account rather than a CSA, if paying from client funds.
What is the effect on my existing pay-for performance trade ideas program?
The good news is that if you are already rewarding your trade idea contributors transparently, your changes are minimal.
Trade ideas programmes are usually run using a pay-for-performance payment model. This model involves a periodic (e.g. quarterly) performance review of the trade ideas each contributor (or firm) submits. Payment is then calculated at the end of the period using the performance results. Reports and feedback are also sent to the contributors. This model appears to be very much in line with the spirit of unbundling under MiFID II.
The one change that some firms are considering is to the pay-for-performance model itself. In principle, pay for performance fits well with the regulators’ objective of only paying for research that adds value to the investment process. Payment for performance is a pure approach to this objective. However, it is possible that some contributors may never be paid. Under MiFID II rules some buy-sides believe there is a risk that these contributors might be seen to be inducing the buy-side to trade. Some buy-sides are considering changes that would mean all contributors are paid at some point, or they must leave the program. A small number of firms have moved to a “pay-for-participation” model, which avoids the risk.
I am a buy-side regulated under MiFID II. Can I pay brokers in the US for their trade ideas in cash?
Historically some brokers in the US have been unable to receive cash payments from clients because they believe this would require them to register as Investment Advisers. In October 2017 the SEC provided a set of No Action letters that make it clear that US brokers can receive payments in cash from Research Payment Accounts in Europe, without having to register as Investment Advisers, for 30 months.
Do I need to have a research agreement with the sell-side to receive trade ideas?
In short, the answer is no: a research agreement is not required. See our comments below on the converse question – does a broker need a research agreement with a buy-side to send ideas (also no).
Sell side questions
How does MiFID II unbundling affect my idea contribution?
It’s likely that your contribution through TIM is largely unaffected. Most TIM clients have transparent reward structures very much in line with regulator requirements. The actual payment mechanism may move from CSA to RPA, but this is likely just to mean money arrives from a different account. The up-side for contributors is that rewards will be more transparent where trade idea programs were previously opaque.
If you send trade ideas to clients that do not have transparent reward structures (whether via TIM or another mechanism), you should consider not sending ideas as you risk appearing to “induce” your client to trade.
Where my only relationship with a client is via trade ideas, do I need to establish a research relationship?
Some broker’s send ideas to clients through TIM, and have no other relationship with that client. We’ve been asked whether there is an implication that the broker must have a research relationship with the client.
We observe that there are many kinds of analytics that meet the requirements of Substantive Research, not just trade ideas. For example, analytics based on directors dealings provided by a third party vendor might meet the requirements of Substantive Research. So a relationship based on trade ideas does not imply that a traditional research relationship is required. Of course, the broker and client must fulfill the usual KYC and AML requirements, and will want at least email confirmation of the terms under which the broker is providing the trade ideas.
What happens if I join a trade idea program that pays for performance, and a client doesn’t pay for my ideas all year? Could I or my client fall foul of inducement rules?
In principle, Substantive Research must be paid for. The maximum free trial period that the FCA allows is three months. However, pay-for-performance idea programs are very much in line with the spirit of the MiFID II regulation. These programs have often paid for the ideas from client funds via CSA on the basis of performance – so some contributors don’t receive payment – and the regulator has not objected: There is a clear evaluation and payment structure, and no reasonable risk that the buy-side is being induced by brokers that are not paid each quarter.
Different buy-sides appear to be taking different action on this question, with some opting to pay a small amount to broker’s at year end if they have not otherwise been paid, some paying a fixed amount for trade ideas regardless of performance, and others not changing their programs.
What is the overall effect of MiFID II on trade ideas and alpha capture?
The immediate effect has been that buy-side firms have clarified their payments structures, or stopped receiving trade ideas. Overall, this has meant some growth in trade ideas through TIM. We anticipate that as the buy-side shifts focus from securing research analyst relationships, asset managers will want to find other effective ways to enhance their returns. Trade ideas have more proven alpha than most alternative sources of intelligence, so we expect continued growth.