Paul Hodgson: Investors come up against the SEC’s isolationism on MiFID

How Europe’s MiFID investment rules impact US investors

The isolationism of the Trump administration seems to be influencing the thinking of the Securities and Exchange Commission, which appears to think that US investment managers are living in a safe harbour US bubble, unaffected by legislation elsewhere in the world.

They seem not to realise that most, if not all, US investment managers have non-domestic holdings and/or operations.

A recent letter from the Council of Institutional Investors (CII) and the CFA Institute called on SEC Chair Jay Clayton to recognise the consequences that MiFID II, the European Union’s second Markets in Financial Instruments Directive, is having – and will have – for US asset managers.

“US retirement funds are now at risk for subsidizing research for others around the world”

The letter urges revisions to the Securities and Exchange Act to ensure that assets used to pay for research are separately disclosed, and that it is disclosed that this research benefits those assets; two of the central tenets of MiFID II. In the US, the cost of trading and research is typically bundled together by broker-dealers and paid for with client trading commissions: nicknamed called ‘soft dollars’.

Both the CII and the CFA Institute have long-standing policies requiring disclosure of soft dollar research. But without action from the SEC, investors “do not know how much of their own assets are being used to pay for investment research, nor can they be confident that the research they are buying even benefits their funds” says the letter.

Since the letter, the issue has been addressed by the Investor Advisory Committee (IAC) at the SEC, while the Commission itself continues to drag its feet since its no-action letter in 2017, effectively allowing broker-dealers to begin to deal with the issue without fear of comeback.

The IAC has recommended two concepts and three guiding principles.

The first concept is to allow research consumers to decide whether they want it unbundled or not.The second is that the SEC might consider “whether fiduciaries relying on the Section 28(e) safe harbor should be required to provide greater transparency about any costs borne by clients in the form of higher commissions for Research”.

The three guiding principles largely call for the protection of all investors in writing legislation.

Ken Bertsch, executive director at the CII, said of this latest development: “We were very pleased with the IAC recommendation. From interaction with Commissioners, we believe they understand the point on unbundling, but are struggling with some complexities on this issue; how best to move forward on this is open to question.

“The IAC recommendation is worded quite astutely to get at what likely is preventing unbundling in the US context.”

Elsewhere, countries have adopted cost transparency and many European asset owners are no longer being asked to pay for research.

With no one left to pay for it, the CII letter says: “US retirement funds, endowments, foundations, and other asset owners are now at risk for subsidizing research for others around the world. And they generally have no transparency into those additional costs.”

In addition, provisions of the Investment Advisers Act mean that some research providers, including broker-dealers, prevent them from accepting payments that are not “explicitly tied to transactions or commissions”, adds the letter.

Fundamentally, the market for research is not functioning like a free market and some research providers have indicated that they will no longer provide research if they are required to register as investment advisers to do so under the Act.

The letter recognises that the SEC “is considering various mechanisms to permit research providers to accept payments from adviser (as opposed to asset owner) funds.” But this is not a solution to the problem, since it means that not only will fewer funds be paying for everyone else’s research but also there is still no transparency in the amount and frequency of payments, nor any information as to whether the research is benefiting even those funds paying for it.