To bundle or not to bundle
Will unbundling have a major effect on practices in European Equity Capital Markets? Will it hinder or help?
As the debate begins to make waves across the industry, EFFAS News examines the background to one of the hot topics headlining the EFFAS conference at Euro Finance Week this month.
The unbundling debate is gaining momentum as guidelines already in place in the UK look set to have a knock-on effect in continental Europe. In particular, the effect on international research and investment activities and the relationship between customers and service providers.
European guidelines laid down by the Markets in Financial Instruments Directive (MiFID) touch on the issues surrounding unbundling, and in particular, transparency. Financial research often comes as part of a package, bundled with additional services undertaken by the provider. Although there is apparently no extra charge for the research, providers do take it into account when calculating their total fees.
When financial research is bundled with other services like this, it can be difficult for customers to see which additional services they are paying for, and which ones are really relevant to them.
Unbundling means customers pay separately for the research they need, so it is not bundled together with other services as one cost. Some see unbundling as a necessary way forward to ensure customers get the best deal possible. Others see it as a flawed attempt to improve transparency in the industry.
Unbundling and transparency
The issues around transparency fall into three main categories:
managing conflict of interest – covering financial services offered in different working relationships; from investment firm and clients or staff members, to staff members and clients as well as between clients.
justifying inducements – to protect the
customer’s best interests, services or inducements they do not directly pay for (such as research) should be disclosed.
best execution – investment firms should work to gain the best possible results for the customer when executing an order, which includes introducing intermediaries, such as firms who receive and transmit orders (RTO firms) or portfolio managers.
And each of these issues has a bearing on the unbundling debate.
Conflict of interest
Conflict of interest can happen when an intermediary (such as an RTO firm or portfolio manager) not dealing on their own account, is contractually linked to a broker providing research free of charge (bundled). Or if the RTO firm or portfolio manager is not tied to one broker but still receives bundled research. For example, where additional research – paid for as part of a package by all customers – is used to the benefit of one group but to the detriment of others who are not part of this group.
This can be justified if the intermediary charges customers different commissions depending on the services required. Although a conflict remains with the execution broker since all customers must pay the same brokerage fees.
Conflict of interest is also clear in instances where the intermediary also deals on their own account as well as customers’. Customers’ best interests can be neglected in favour of the investment firm’s own dealings using research paid for by the customer. This is impacted further if people responsible for the firm’s own dealings receive the information first, or the firm’s own transactions are subject to a lower commission rate.
Inducement
Financial research free of charge is used as an inducement to gain business from intermediaries and must be disclosed to the customer. However, what and how much should be disclosed and how useful it is to customers is ambiguous. One thing that is clear: it doesn’t make the value of the bundled research transparent.
In this case, if research was unbundled, therefore paid for separately, no disclosure would be necessary. Why? It is no longer an inducement.
If the intermediary is also working on their own account, inducements do not present a conflict of interest. So long as the intermediary does not use the information for their own benefit or the detriment of the customer, in terms of cost and timing.
Best execution
These different working practices must all meet the requirements of best execution. Of paramount importance: the total cost of the transaction should be competitive for the customer, which may not be the case if the broker calculates the cost of the research into their commission.
In this instance, unbundling the financial research may be an appropriate move.
Some may argue that as bundled and unbundled research are two different services, they cannot be compared in terms of best execution. EFFAS differs from this opinion, taking the view that the commission structure does not make a distinction as to whether, in specific transactions, the financial instrument is affected by research if it is bundled or not. But bundled research can be said to affect execution. If bundled research makes an execution channel more expensive it should be avoided by an intermediary firm for the sake of best execution.
Rather than impose requirements on bundling or unbundling research, the MiFID sets out guidelines to protect customers in both cases. Unbundling might lead to greater transparency and may ease a firm’s task to be more transparent, particularly in the case of disclosing the amount or method of calculation of a non-monetary benefit, such as research.
Firms who bundle research into transaction costs may make their costs higher than those of competitors who unbundled it. In this case firms may well bundle themselves out of the business.
Take part in the unbundling debate at the EFFAS Conference on 22 November, part of Euro Finance Week. Or email your views to the EFFAS newsletter team at info@effas.com
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