ESMA accused of not understanding fund management

European securities regulator Esma has been accused of failing to understand how fund managers make investment decisions in framing its December draft of technical standards for Mifid II.

“The framework governing how broker research should be paid for fails to understand the mechanics of fund management,” argued Urban Funered, director of public policy corporate affairs at Fidelity Worldwide Investment, speaking at the recent conference hosted by the Association of the Luxembourg Fund Industry (Alfi).

At present, advice from the European Securities and Markets Authority (Esma) to the European Commission concerning so-called level 2 measures under MiFID II prevents broker commissions from being used to pay for investment research directly.

Executing brokers currently put aside a portion of the commission paid by managers into a separate account. Every quarter managers then rate the quality of the research provided by the firms that execute its trade and this portion of the commission is re-distributed to brokers at the top of the list. This practice is known as commission sharing agreements (CSAs).

Esma argues that paying commissions directly conflicts with the requirement for fund managers to provide best execution to clients, since managers are more likely to execute with brokers that have provided them with good research.

The rules characterise the wider objective of Mifid II “to atomise the various services and costs involved in fund management and private banking”, according to Hermann Beythan, a partner at Linklaters in Luxembourg.

But Funered raised objections to the claim that good research induced managers to execute with the broker who published it. He noted that if a fund manager issued a request to its execution desk to buy a certain stock, “the trading desk would not know where the manager got the idea from."

Chinese walls between fund managers and trading desks meant that even if the manager wanted to reward the broker from which the ideas came, he/she wouldn’t be able to. Besides, “traders would be in big trouble if they did not get best execution for their clients”, said Funered.

The December draft by Esma provided an alternative to paying for broker research directly: obtaining permission from the client via a specific agreement.

However, managers argue that striking detailed new contracts with every underlying client would be impossible to implement. They wonder if managers would have to ask permission from every investor in a mutual fund, for example, and query what would happen if investors in the same fund gave different answers.

Funered said that even if it was possible to implement it would create a “free-rider problem”. Say a manager runs a segregated account for an institutional investor and a mutual fund for retail investors. The institutional fund refuses to pay for the research, while the mutual fund pays for it.

“The fund manager still uses the knowledge he has in making decisions for both funds,” he said, regardless of where that knowledge had been gathered. 

While the principal of unbundling fees is a good one, Beythan said the danger was that atomising fees “to the last detail” created an overwhelming administrative burden that affected consumers as much as managers. “The danger is that the consumer will see all of the trees, but no forest,” he said.

Nevertheless, the chances of provisions such as this being softened were “rather slim”, he acknowledged, adding: “More likely is that in several years the European Commission may become aware of the downside of this approach."