Seeking Clarity on MiFID II Inducement Trading Rules

With MIFID II’s rules on inducements now a reality, buy-side firms are paying close attention to the costs associated with their front-office trading platforms and analytics.

The EU regulation, which took effect on Jan. 3, could draw scrutiny to execution services and tools that are sponsored by brokers, such as order management and execution management systems as well as trade analytics.

“In order to align with MiFID II’s inducement regulations, the buy side has an obligation to understand what a third party is paying for and what is being paid for on their behalf,” said Spencer Mindlin, analyst at Aite Group on a recent webinar.

While MiFID II has been focusing on unbundling research payments from executions, there is a lot of ambiguity around the industry practice of brokers paying for vendor-sponsored buy-side client connectivity (i.e., FIX lines) and how that is going to align with MiFID II inducement regulations, said Mindlin on the webinar.

For example, some buy-side firms may be receiving an EMS free-of-charge from their sell-side firms, which are sponsoring the third-party systems by paying the vendors a fee for connectivity. Thus, brokers could be utilizing part of their trading commissions to compensate third-party vendors, on their behalf.

Under MiFID II, an investment firm providing portfolio management or investment advice to clients cannot accept anything free from the sell-side if it could be considered an inducement to trade.

“All in all, MiFID II will require a higher level of compliance from the buy-side than it is used to, especially concerning investment research and the topic of inducement,” according to RegTech in “The new MiFID world: research from the buy-side perspective.”

Article 24 (8) of MiFID II prohibits investment managers accepting “fees, commissions or any monetary or non-monetary benefits paid or provided by any third party,” summarized RegTech. “In principle, this reform will still allow investment firms to receive research from third parties, but greatly limits its scope in order for the action to not contravene inducement rules.”

Though an EMS is not specifically mentioned in MiFID II, it’s possible that the receipt of an EMS on a free-of-charge basis could be considered “a non-monetary benefit” under MiFID II.

FCA Offers Clarification on MiFID II & Inducements

A policy statement from the UK’s Financial Conduct Authority released in July 2017, sheds some light on these MiFID II implementation issues.

“We take the view that certain activities can be considered as inherent to the provision of execution services and received by the underlying client in return for execution costs and charges,” stated the FCA’s PS17/14.

For instance, the FCA guidance suggests that an investment firm could accept transaction reporting from a broker as part of the execution service being provided to clients. This is acceptable provided that “a reporting system does not influence best execution, and it’s offered as a standard term of business by the broker to everyone,” notes the UK regulator. [The FCA would frown if the service were selectively offered for free to certain clients and not to others.]

A key distinction is made between a broker providing a service, such as working a large order or structuring a series of derivatives trades, which is part of the execution service itself, as compared to providing a separate benefit.

“However, order transmission systems used by a broker (such as FIX networks), do not appear to be provided to either the firm or its clients as a distinct benefit,” according to the FCA.

The FCA interpretation does not apply to services that are not related to the execution of an order and its proper settlement and reporting.

“Provision of third-party analytic tools, order management systems, or RPA [Research Payment Account] administration services to a MiFID investment firm, are not inextricably linked to an execution service,” stated the FCA.

According to Mindlin, though there is a lack of clarity in how the MiFID II inducement rules apply to OMSs and EMSs, asset managers have an obligation to understand how much their systems cost and who is paying for it.

“They also need to know what they don’t know is being paid for to comply with MiFID II, said the analyst.

As a result, MiFID II is triggering a focus on total cost of ownership or TCO, according to the Aite Group webinar and report “Total Cost of Ownership and the OMS/EMS Pivot Point.”

Fund managers are also incurring additional costs to comply with MiFID II on best execution and transaction reporting, and this is causing firms to re-evaluate their investment technology platforms. As a result, there is a lot of interest in what TCO is, said Mindlin.

Based on research conducted in late 2016 with asset managers and again in 2017’s Q2 and Q3 with executives at global hedge funds, Aite asked firms about both direct and indirect costs of their OMS and EMS platforms.

According to the report, hidden and indirect fees are difficult to quantify and even some managers who are familiar with the fees are unaware of them.

Indirect costs included network and broker connectivity fees, once again referring to FIX networks. “These connectivity fees were initially a negligible cost for the broker doing business, especially relative to the commission it would generate,” said Mindlin.

However, buy-side respondents told Aite that fees have not been adjusted downward alongside reductions in trading volume and declines in broker revenues.

In addition, there is ambiguity around [what] brokers pay for in terms of vendor-sponsored activity, said Mindlin.

Some of the larger hedge funds were critical of their vendors for obscuring the totality of the revenue earned rom their accounts.

It remains to be seen how the EU inducement rules will impact payment methods for trading technology. And if asset managers need to pay a separate charge for their FIX networks, then this could lead them to consolidate the number of brokers that they execute through.

Regulations such as MiFID II are clearly raising the bar on the buy side needing to understand costs, said Mindlin, adding that TCO is going to drive that conversation.