Mifid II research unbundling hits Japan’s asset managers

Japanese and European investors may face different payment models for investment research

Posing a challenge: Mifid II rules will make research more complicated for firms in Japan

Europe’s new regime for securities markets poses a challenge for Japanese asset managers, pressuring local regulators to ease the burden.

From January 3, 2018, the European Union’s second Markets in Financial Instruments Directive (Mifid II) requires asset managers to separate payments for sell-side analyst research from trading commissions. But Japanese rules require asset managers to charge only one set of fees to end-investors, which means local asset managers who raise money from European clients will find it difficult to comply with both regimes.

“This is a massive issue for [Japanese] asset managers and it is going to be difficult for them to comply,” says Vijay Chander, executive director of fixed income at the Asia Securities Industry & Financial Markets Association (Asifma). “How can they use a completely different payment model for [research on] the exact same stock, depending on whether this stock ends up in a fund for Japanese investors or a fund that is distributed in Europe? This will require a complete reorganisation of the way they do business.”

Japanese rules require firms that receive separate research fees to register as independent investment firms. While there are other jurisdictions in Asia with the same regime, Japan has the most at stake. Foreign investors owned 30% of all Japan-listed stocks in value terms as of March 31, according to data released by Tokyo Stock Exchange and other exchanges in June. Such investors also account for roughly 70% of trading in Japanese shares.

The situation of Japanese firms is also quite similar to their peers in the US, where accepting direct payment for research means having to set up as an independent adviser. However, the US firms were granted a 30-month reprieve to comply with the changes by the US Securities and Exchange Commission on October 26 – the first example of a non-EU regulator explicitly changing its rules to make Mifid II compliance easier.

For global asset managers based in Asia, Mifid II could force them to implement changes across their entire organisations to avoid the inefficiencies caused by maintaining differing practices and processes across geographies. But, for Japanese firms, the solution might not be that simple.

Historically, research fees were not separated and were paid for by end-users out of the total investment management fees. To meet Mifid II, funds will either have to set up a separate research payment account (RPA), through which their clients pay for research, or absorb the cost of the research themselves.

At some point, investors who are paying for research are going to ask why other investors are getting a free ride at their expense
Head of Asia at a global brokerage

The problem for Japanese asset managers is that only European investors have to explicitly pay for the research component of their investment, and fund managers do not have clarity on the reaction of Japanese investors, who may be investing in an almost identical fund.

Asifma’s Chander says meeting Mifid II requirements for European clients only might set the Japanese asset managers at odds with their fiduciary responsibility, which holds the allocation of shares across funds should be equitable.

One method to meet the two conflicting regulations would be for a Japanese asset manager to carve out the research component from a fund when offering it to European investors and charge it separately. But this could create unfair treatment of investors.

“At some point, investors who are paying for research are going to ask why other investors are getting a free ride at their expense,” says the head of Asia at one global brokerage active in Japan.

Alternative solution

Several global banks offering analyst research in Japan report that an alternative solution being considered is to allocate a budget for research at the beginning of a trade, which would gradually be consumed over the trade’s lifetime.

“You are really just creating a virtual price and changing the psychology of investors by leading them to understand there are two separate price components – one for research and one for trading – which has not existed as such before in the Japanese market,” says Stephane Loiseau, head of cash equities and global execution services for Société Générale in Asia.

Loiseau says this arrangement can be managed through a commission-sharing agreement (CSA). However, while this might satisfy the Japanese regulators, by keeping the payments for research and execution together, global banks that have been exploring this option acknowledge it might not comply exactly with the letter of Mifid II.

“If you look at the strict application of the regulations, research should be paid from a separate RPA, set up in advance with clearly-identified cashflow going into it. The question is how much leeway there will be for the regulators to accept these quasi-CSA arrangements for the next six to nine months,” says Loiseau.

Loiseau’s viewpoint is echoed by others in the market, who believe that come January 3, European regulators will have no choice but to give some leniency to those who have made their best effort on the implementation of Mifid II, but are not yet in full technical compliance.

Changing the law

Japan’s Financial Services Agency (JFSA) has indicated it does not have any plans at present to grant any form of relief to asset managers who have to deal with Mifid II’s research unbundling requirements. Nor does it plan a change in the law that would make it easier for firms to charge separately for research. But the regulator is likely to face increasing pressure to make some concessions.

“Decoupling or unbundling of the research from other services evens the playing field for listed products, sending liquidity to the desk that is best in executing and promotes overall efficiency,” says Stéphane Martin, head of institutional sales in Asia for Vantage Partners, an agency broker specialising in equity derivatives, servicing both asset managers and sell-side firms. “Big buy-side firms will seek the best execution capabilities, and clearly clamour for a certain level of compliance and transparency [in Japan] in line with global standards.”

However, changes could also hurt the commissions received by banks for research and advisory services. The US and Japan have remained two of the more resilient markets, with allocations to research and advisory services relatively stable at about 60% of cash equity commission payments, according to financial services research firm Greenwich Associates.

In contrast, large institutional investors in the rest of Asia are already cutting back on commission payments used to compensate sell-side providers for their equity research and advisory services. A report by Greenwich Associates found the share of payments for such services slipped to 56% in 2016 from 64% in 2014.

Unless there is a wholesale move to listed contracts, the unbundling of research from execution and other trading services could ultimately hurt price discovery
Stéphane Martin, Vantage Partners

Since Tokyo often follows Washington’s lead when it comes to the implementation of global regulation, many market participants think the JFSA might issue a ‘no action relief’ letter in the style of the SEC. But few believe the JFSA will take things further and actually change the dynamics of the home market by allowing the unbundling of research.

“Japan is quite a complex market, with a prominent over-the-counter market for single stocks and exotic products. The asset managers are reliant on banks to discover the price of the OTC products. Unless there is a wholesale move to listed contracts, the unbundling of research from execution and other trading services could ultimately hurt price discovery,” says Martin of Vantage Partners.

Sawako Ueno, a partner at Deloitte in Tokyo, says Japanese regulators have been taking a close interest in Mifid II, but it is other aspects of the regulatory package that might influence Japanese law rather than the research unbundling component.

“Japanese regulators are looking at Mifid II as a kind of model and may eventually take some of these requirements into their own guidance, but I’m not sure whether research unbundling is really needed in the Japanese market,” says Ueno. “I think the [Mifid II] rules around fee disclosure would be much more [relevant].”

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