On the back of Deutsche Bank’s recent ordeal, Finance Monthly gets the lowdown from Zac Cohen, General Manager at Trulioo, who discusses the steps banks and other financial institutions can take to strengthen their fight against money laundering.

Deutsche Bank recently made headlines after the German financial watchdog BaFin appointed an independent auditor to monitor the bank’s Anti Money Laundering (AML) compliance. This is the first time such an appointment has been implemented, highlighting the bank’s failure to meet due diligence requirements surrounding terrorist financing, money laundering and other illicit flows of capital.

As banks and financial organisations now operate in an increasingly global marketplace, they must grapple with the consequences of handling cross border transactions. Having lax Know Your Customer (KYC) procedures in place can be potentially crippling for banks worldwide, with fines being issued in the hundreds of millions if chinks in their anti-money laundering armour are uncovered.¹ Yet despite over $20 billion being spent on compliance annually, only 1 per cent of illicit transactions are seized each year.²

Financial globalisation, still very much a reality despite shifting geo-political attitudes towards it, makes international money laundering practices a real force to be reckoned with. Indeed, international money laundering is becoming more widespread and this is, in part, down to the difficulties in maintaining full transparency when dealing with international clientele.

Banks and other financial institutions are legislatively obliged under Anti-Money Laundering rules to have full knowledge over their clients’ identities and the origins of their wealth. With money coming in from all corners of the globe, banks must be able to perform Know Your Customer (KYC) and Know Your Business (KYB) checks on a client base that may be moving money all around the world. In addition, establishing a “beneficial owner”, a derivative of KYC, must be a priority before financial transactions occur. The 4^th Anti Money Laundering Directive (4AMLD) stipulates the necessity of ascertaining the beneficial owner of business customers, partners, suppliers and other business stakeholders. Some transactions, originating from unknown geographic localities, can be particularly difficult to verify.

The key to combatting this problem is leveraging the available technologies that can be implemented to help promote transparency. This is crucial as these technologies have the view to reducing the occurrence of fraudulent transactions passing through banks and financial institutions. Bad actors are becoming increasingly sophisticated in their techniques in directing fraudulent money through banks, employing techniques such as under- or over-invoicing, falsifying documents, and misrepresenting financial transactions. This increasing sophistication that coincides with the rise in global money laundering, up 12 per cent from the previous year.³

There are however, multiple technical advances that are available to help implement and streamline the process of checking and verifying ultimate beneficial owners and promoting transparency. Automated systems and artificial intelligence programmes can be used to scour company documents for a streamlined electronic ID verification sytems to verify personally identifiable information in conjunction with ID document verification and facial recognition technology to help paint a full picture of each beneficial owner of a business.

Putting this all together to create certainty and transparency about who you’re doing business with is crucial. Deutsche Bank have suffered severe reputational damage as a result of several anti-money laundering breaches that have reached the public’s attention over the last few years. The question remains, can banks implement the technology and processes they need with sufficient effectiveness to recover from this reputational strain?

1 https://www.reuters.com/article/us-deutsche-bank-moneylaundering-exclusi/exclusive-deutsche-bank-reports-show-chinks-in-money-laundering-armor-idUSKBN1KO0ZC

2 https://www.politico.eu/article/europe-money-laundering-is-losing-the-fight-against-dirty-money-europol-crime-rob-wainwright/

3 https://www.pwc.com/gx/en/services/advisory/forensics/economic-crime-survey.html

Although the Markets in Financial Instruments Directive II (MiFID II) was implemented at the start of the year, work for the financial services industry to comply with this new regulation is far from over. Still remaining are a number of uncertainties, with multiple milestones and deadlines for specific requirements set throughout 2018 and beyond.

Hailed as one of the biggest overhauls of the financial services industry in decades, MiFID II introduced 1.4m paragraphs of rules and a number of new obligations for firms operating in the sector. These included new and extended transparency requirements, new rules on payments for research, increased competition in trading and clearing markets and guidelines to promote financial stability. With many of these rules being delayed or their introduction staggered over the course of the year, there is still a challenging path for the industry to navigate.

Below, Matt Smith, CEO of compliance tech and data analytics firm SteelEye, explains for Finance Monthly the key steps financial organisations should take over the course of the year to ensure they are meeting MiFID II’s demands.

Q2 2018: Best execution under RTS27 and 28

MiFID II has two major “best execution” requirements which must be met by financial services firms – regulatory standards RTS27 and 28. As part of their obligations, RTS28 mandates that firms report their top five venues for all trading. With a deadline of April 30, the purpose of RTS 28 is to enable the investing public to evaluate the quality of a firm’s execution practices. Firms are required to make an annual disclosure detailing their order routing practices for clients across all asset classes.

Obligations include extracting relevant trade data, categorising customers and trading activity, formatting the data correctly in human and machine readable formats, adding analytical statements and placing all of this information in a publicly available domain.

Limiting disclosure to five trading venues makes complying with these obligations relatively simple for small firms with straightforward trading processes. As a firm’s activity increases in complexity, however, so does its reporting obligation and managing RTS28’s data component could become a significant burden, as compliance departments spend time classifying trades, normalising data, formatting reports and completing administrative tasks.

RTS28 is followed soon after by RTS27, which will hit the industry on June 30. RTS27 requires trading venues to provide quarterly best execution reports, free of charge and downloadable in machine readable format, and is intended to help investment firms decide which venues are most competitive to trade on. All companies that make markets in all reportable asset classes that periodically publish data relating to the quality of execution will be required to comply with RTS27.

The necessary publication of these reports requires the gathering and analysis of a significant quantity of data, which must detail price, costs, speed and likelihood of execution for individual financial instruments. Investing in the right technology ahead of the June deadline will ensure firms have the solutions needed to help digest such data and analyse it to inform their trading decisions. As we move through 2018 and 2019 however, analysis of this data, rather than being an additional burden, should help firms refine their best execution processes and generate a competitive business edge.

Q3 2018: Increasing transparency under Systematic Internalisers

One of MiFID II’s main aims was increasing transparency in the financial services industry in an attempt to avoid repetition of the 2007-2008 financial crash. In order to do this, a number of new rules attempting to regulate ‘dark pool’ trading were implemented, allowing regulators to police them more effectively and bring trading onto regulated platforms.

This system of increased transparency is designed to be effected through MiFID II’s new expanded Systematic Internaliser (SI) regime, the purpose of which is capturing over-the-counter trading activity to increase the integrity and fairness of industry trading and reduce off-the-book trades. For a firm to become an SI, they must trade on their own account on a ‘frequent and systematic basis’ when executing client orders. However, it is currently unclear what precisely ‘frequent and systematic’ means and as a result, many in the industry have been left without the necessary guidance to be able to implement these new rules correctly.

In August 2018, ESMA is set to publish information on the total number and volumes of transactions executed in the EU from January to June 2018. Any firm that has opted in under the regime or that meets the pre-set limits for ‘frequent and systematic’ basis will thereafter be classified as an SI under MiFID II.

The deadline for SI declaration follows shortly afterwards in September, which is when investment firms must undertake their first assessment and, where appropriate, comply with the SI obligations, which will become a quarterly obligation from then on.

Firms’ reporting obligations will increase considerably should they be classed as an SI. They will be required to notify their national competent authority; make public quotes to clients on request for their financial instrument; publish instrument reference data, post-trade data, and information on execution quality; and disclose quotes on request in illiquid markets. Adopting an effective pre- and post- trade transparency solution can help any firm set to be classified as an SI in September meet their obligations well ahead of the deadline in four months’ time.

Q4 2018: The impact of the pricing of research

Another major change under MiFID II is the regulation’s new rules on payment for research, which had previously been distributed to fund managers, effectively free of charge, but paid for indirectly through trading commissions. The provision of equity research is now considered to be an inducement to trade and the sell-side is only able to distribute their research to fund managers that pay for it. Moreover, an extra burden of red tape and reporting is being introduced as, by the end of 2018, investment firms must have provided clients with detailed information related to the costs and associated charges of providing investment services.

Research has effectively moved from an unpriced to a priced model and fund managers are now having to find a budget for research, with most firms electing to absorb that cost, which will inevitably impact their bottom line. The sell-side meanwhile will have to grapple with how to price their research, an unenviable task, given JPMorgan’s strategy to grab market share from smaller rivals by charging $10,000 for entry-level equity research.

Even before the aggressive pricing strategy adopted by the investment banking behemoth, the sell-side was facing consolidation and significant analyst job losses as the shrinkage of overall payments for research services to investment banks continues and asset managers become increasingly selective about the products and services they procure from investment banks. What is already certain is that the pricing and quality of investment research will be subject to closer scrutiny than ever before, driving up competition among research providers and triggering fragmentation and innovation in the marketplace.

Q1-2 2019: The UK’s departure from the European Union

While the FCA has stated that Brexit – at least currently – will not have an impact on their enforcement of MiFID II rules, the UK’s departure from the EU still leaves considerable uncertainty for those in the market. One recent survey found that 14% of surveyed compliance professionals had no idea how Brexit would affect their compliance requirements.[1] There is speculation that the UK could opt for ‘MiFID II-lite’ in all or some areas in order to better align it with the UK’s financial markets. This could mean that, while the industry must comply with MiFID II for this next year, after April 2019 a whole host of new rules and amendments could come into force.

As one of the core architects of the MiFID II rules, including many of its record-keeping and reporting principles, the FCA is unlikely to favour watered-down standards that could see London regarded as a less safe or transparent marketplace. However, with so much still up in the air, preparations should be made in order to ensure a swift transition once Brexit comes into force.

The strength of the UK’s regtech and fintech offering means the City should be well-placed to adapt to whatever shape MiFID II takes post-Brexit. To help prepare, strategy teams should work on plans for various post-Brexit scenarios in order to help weather the challenges that the UK’s EU departure will bring. UK players will undoubtedly emphasise their strengths in financial talent, product development, AI, fintech and regtech, helping the UK retain its leading position in the European financial market.

[1] https://www.thetradenews.com/uk-compliance-managers-predict-mifid-ii-exemption-post-brexit/

As we herald a new era of banking, will PSD2 result in FinTechs challenging the dominance of traditional banking services?

13^th January 2018 marked the beginning of the Open Banking era. The EU’s Second Payment Services Directive (PSD2) which took effect earlier this month forces banks to allow third parties, including digital start-ups and challenger banks, access to their customers’ financial data through secure application programming interfaces (APIs), and create a new way for customers to bank and manage their money online. If all goes to plan, PSD2’s main objective is to ensure maximum transparency and security, whilst encouraging competition in the financial industry. The Open Banking revolution aims to create a form of cooperation between banks and FinTechs – however, this doesn’t seem to be the case 18 days after the triggering of PSD2, with a number of banks that still haven’t published their APIs and incorporated the necessary changes. Naturally, the directive is good news for the FinTech sector. FinTech companies and digital payment service providers will gain greater access to high-street banks’ customers’ financial data – something that they’ve never had access to in the past. This will then undoubtedly inspire FinTechs to develop new innovative payment products and services and provide users with opportunities to improve their financial lives, whilst allowing them to compete on a more-or-less level playing field with the giants of the financial services industry, the traditional banks. Does this mean that traditional banks will need to up their game when competing with the burgeoning FinTech industry? Are they scared of it, and if not – should they be?

Traditionally, and up until now, banking has always been a closed industry, monopolising the majority of other financial services. The recent advancement of digitisation has shaken the industry, with FinTech start-ups offering alternative solutions to more and more clients across the globe. From a bank’s point of view, PSD2 will forever change banking as we know it, mainly because their monopoly on their customers’ account information and payment services is about to disappear. Banks will no longer be competing against banks. They will be competing against anyone that offers financial services, including FinTechs. And even though the directive’s goal is to ensure fair access to data for all, for banks, PSD2 poses substantial challenges, such as an increase in IT costs due to new security requirements and the opening of APIs. However, the main concern is that banks will start to lose access to their customers’ data.  Alex Bray, Assistant VP of Consumer Banking at Genpact believes that a possible outcome of Open Banking is that banks could end up surrendering their direct customer relationships. If they don’t acknowledge the need for rapid change or move too slowly to adapt to the landscape, they risk becoming “commoditised payment back-ends as new aggregators or payment initiators swoop in”.

However, Alex Bray also argues that for banks to take advantage of PSD2, “they will need to find a balance between openness, privacy and data protection.” There is also a case to suggest that traditional banks who embrace and utilise the new directive to its potential could transform a potential threat into a huge opportunity. He also suggests that: “they [banks] will need to improve their analytics so they and their customers can make the most of the huge amounts of new data that will become available”. Only a well-thought-out strategy will help banks to survive the disruption to the long-established financial industry – and cooperating with FinTechs can be part of it. Alex Kreger, CEO of UX Design Agency suggests that “Gradually, they [banks] could turn into platform providers of banking service infrastructure… As a result, successful banks may lose in service fees, but they will gain in volume. Many FinTech start-ups will not only offer services on their platform, they will actively introduce innovative products designing new user experiences, thereby enriching the financial user’s journey and transforming the banking industry. This will attract new users and provide them with new ways of using financial instruments.”

Only time will answer all the outstanding questions related to the open-banking revolution. FinTech firms are expected to ultimately benefit from all these changes – however, whether the traditional banks will cohere to the new regulations quickly enough, whilst finding ways to adapt to them, remains to be seen.

Craig James, CEO of Neopay, tells Finance Monthly PSD2 will prove to be the most beneficial piece of legislation for fintech companies in years, and could completely change the face of the UK banking sector.

While technology has grown increasingly important in the financial sector, the “traditional” industry has been slow to adapt as consumers grow more frustrated by the lack of progress.

Innovative start-ups, looking to fill the gap left by the traditional establishment’s hesitation to change, have been growing in prominence as some banks, regulators and the government try to encourage new ways for businesses to engage with customers in a market suffering a long-standing loss of reputation.

Coming into force in January next year, the EU Payment Service Directive (PSD2) is the latest change facing one of the country’s oldest institutions, and could prove the catalyst for a technology revolution in the sector driven by innovation in personal banking.

Putting consumers at the heart of the fintech revolution

The most substantial change in PSD2 is enabling customers to allow third party businesses – like technology companies – to have access to all their bank data.

For fintech companies focussed on bringing new products to the market, this presents a new opportunity to create these offerings, without the infrastructure costs facing traditional banks.

Personalisation has been a buzzword in banking for some time, and there is no shortage of products from savings accounts to credit cards that are promoted as tailored to a customer’s needs.

However, while banks can provide a card with an interest rate suitable to the customer, the current offerings are incapable of working across multiple accounts, and cannot adapt to real time changes to a consumer’s individual circumstances.

PSD2 opens the possibility for fintech businesses to create “one stop shop” apps for bank services, allowing a customer to access and manage every aspect of their financial footprint from a single point.

These technology based products will put the consumer back at the heart of banking as businesses will be forced to adapt their products, or face getting left behind by smaller technology businesses which can suddenly offer better services.

It will also open entirely new ways for consumers to manage all aspects of their financial needs.

Better budgeting

There is already a plethora of products which can help customers with their finances, but they are severely limited in essentially being a replacement for paper based tracking. The onus is still on the customer to stay on top of the information.

However, by getting access to a person’s account information and financial history, a fintech company could create a genuinely personalised budgeting tool which could remove the management aspect from the customer.

By being able to monitor balances and outgoings in real time, these apps could be programmed to learn when particular bills are due and, if one account is lacking funds to pay, the app could notify a customer and then automatically transfer money from another account – or combination of accounts.

Considering that most people have more than one active bank account, this type of capability could prove invaluable for customers, helping them avoid unnecessarily falling into debt because they failed to move money around in time.

Real time debt solutions

For those customers who have already fallen into debt, new technology based bank apps could be created to offer real time solutions to help consumers pay down the money they owe, and get out of difficulties.

One of the major frustrations with current banking services, according to our research, is that balance updates are not always immediate and in some situations a user is not being shown an accurate account of their financial situation – which makes it hard to make decisions.

New banking apps could greatly benefit these customers by assessing their income and spending habits – while updating account balances in real time – and instantly suggest ways that customer could reduce their out-goings.

There is also the potential for banks to adopt these kinds of apps, which could be used to find or suggest savings plans.

The biggest benefit of this wave of products over existing services, is that they could monitor activity across multiple accounts in real time. The real-time aspect of these tools could help customers by instantly alerting them to unusual activity or if an account is in danger of becoming overdrawn.

While the “traditional” banking sector is at risk of being left behind by the speed of technological change there remains great potential for banks and fintech companies to introduce a wave of new products and tools for consumers that can help them manage their personal finances better.

PSD2 could kickstart the biggest chance the banking sector has experienced and, in the long run, will prove extremely beneficial for those institutions most able to implement technology at the heart of the customer offering.

Gordon Dadds, the legal and professional services firm, is urging the UK property sector to get to grips on the 4^th EU Anti-Money Laundering Directive or face receiving a hefty financial penalty which could be unlimited.

The Directive which comes into force from today (26^th June 2017), combined with the new investigation power being introduced by the Criminal Finance Act 2017, is going to impact the UK property industry significantly with banks and estate agents having to carry out further due diligence on both the buyers and sellers of property which will slow down the buying process by up to 186 days. There will also need to be formal risk assessments and nominated officers will have to be re-appointed if not currently an executive sitting on a board (or equivalent) of the business.

Gordon Dadds predicts that the new regime will increase workloads due to the required volume of administration with all polices now needing to be tailored to each client case and for the usual terms of business to be updated. This doubling of the workloads will increase company costs with existing staff requiring training and in a high proportion of cases, estate agents needing to recruit staff in order to help with the administration burden. We estimate this could cost the largest estate agents a combined additional cost of £6million.

Alex Ktorides, Partner at Gordon Dadds, says: “The Directive is a shake-up of the way that banks, estate agents and other parts of the regulated sector apply a risk based approach to customers. They will now have to consider the characteristics of the customer, the product and its distribution and the jurisdictions involved in determining the lengths that they have to now go to in terms of conducting due diligence on their clients. There is even a new requirement to force overseas branches of UK parent companies to apply UK standards. This will cause huge concerns to international businesses and even encourage moving head office from the UK.”

The property sector now has to act quickly in order to ensure it complies with the Directive. The purchasers and the seller are both now included in the application of customer due diligence, meaning additional checks will need to be carried out by estate agents, auctioneers and surveyors.

Alex Ktorides continues: “This is going to create substantial challenges for the property sector especially given the final version of the directive has only been made public today which has left no time for banks, estate agents and the lending sectors among others to update their policies and processes alongside training staff on the new regime. Some agents have in excess of 100 branches and have received no prior time to implement the new processes in order to comply.

“For many smaller estate agents (and surveyors) this will be the first time they will have carried out checks on both the buyers and sellers and they are going to have to get up to speed with the regime as quickly as possible or risk facing an unannounced visit from the HM Treasury.”

Gordon Dadds is calling on the UK property sector to act fast and to start to get to grips with the Directive from today. For many medium to large sized estate agents Gordon Dadds recommend they appoint a money laundering officer and a deputy to help with the increased work load and to ensure they are compliant and not falling foul of the regime which could spark a warning or fine from the HM Treasury.

(Source: Gordon Dadds)

With the implementation of GDPR on our doorstep, companies risk serious vulnerability in the face of data protection. This week Finance Monthly has heard from Rafi Azim-Khan and Steven Farmer of Pillsbury Law, who gave us a rundown on how you need to prepare for the regulatory changes.

From the debate about the UK’s ‘Snooper’s Charter’, to a number of high-profile cyber-attacks and the wrangling, both legal and political, over the abolition of the EU-US data sharing treaty, Safe Harbour, data privacy has remained firmly in the media spotlight in recent months.

Following the most significant overhaul of the EU data protection regulations in recent years set to come into effect with the introduction of the EU General Data Protection Regulation (GDPR) in May 2018, this trend looks set to continue.

The GDPR rips up the existing legal framework and provides for the imposition of heavy fines. Equally seismic is the fact that the new rules have an extra-territorial reach, catching companies who traditionally did not need to prioritise data protection laws.

Significantly, however, few businesses are reported to have actually looked at what they need to do to ensure compliance under the GDPR. As the time until enforcement dwindles, it is essential that firms act, as the UK data protection regulator has said herself. So what do companies actually need to be aware of?

The letter of the law

The GDPR replaces the current EU Data Protection Directive 95/46/EC. As a Regulation, and unlike the old law, the new laws will be directly applicable in all EU member states.

Specific changes introduced include the following:

• Accountability – crucially, those caught will be required to show compliance e.g. (i) maintain certain documents; (ii) carry out Privacy Impact Assessments; (iii) implement Privacy by Design and Default (in all activities), requiring a fair amount of upfront work.

• Data protection officers (DPOs) – in many circumstances, those caught by the GDPR will also need to appoint DPOs and so thought will need to be given as to whether this applies and, if so, who that person or persons might be.

• Consent – new rules are also introduced relating to the collection of data, e.g., consent must be “explicit” for certain categories. Existing consents may no longer therefore be valid and consents obtained should be purged going forward.

• Enhanced rights for individuals – new rights are introduced around (i) subject access; (ii) objecting to processing; (iii) data portability; and (iv) objecting to profiling, amongst others.

• Privacy policies – fair processing notices now need to be more detailed, e.g., new information needs to be given about these new enhanced rights for individuals. Policies will need updating therefore.

• International transfers – Binding Corporate Rules for controllers and processors as a means of legitimising transfers are expressly recognized for the first time and so should be considered as a transfer mechanism.

• Breach notification – new rules requiring breach reporting within 72 hours (subject to conditions) are introduced and so processes in place (or not) will need to be revisited to accommodate these rules.

Of course, with the UK set to leave the European Union, there is much ongoing discussion about what the post-Brexit regulatory regime may look like. It is generally accepted, however, that after the UK leaves the EU, UK laws will nevertheless track the GDPR (e.g. via some form of implementing legislation or a new UK law which effectively mirrors the GDPR). In other words, even if you are purely a UK company, or you are outside the UK and targeting UK consumers only, you should not ignore these changes on the basis Brexit is some sort of get out of jail free card.

Who needs to comply?

All organisations operating in the EU will be caught by the new rules. Importantly, organisations outside the EU, like US-based companies that target consumers in the EU, monitor EU citizens or offer goods or services to EU consumers (even if for free), will also have to comply.

The GDPR also applies to “controllers” and “processors”. What this means, in summary, is that those currently subject to EU data protection laws will almost certainly be subject to the GDPR and processors (traditionally not subject) will also have significantly more legal liability under the GDPR than was the case under the prior Directive.

What can businesses do to prepare?

To ensure compliance, companies need to ensure that they have robust policies, procedures and processes in place. With the risk of heavy fines under the GDPR, not to mention the reputational damage and potential loss of consumer confidence caused by non-compliance, nothing should be left to chance. In terms of key first steps, companies might consider prioritising the following as a minimum:

• Review privacy notices and policies – ensure these are GDPR compliant. Do they provide for the new rights individuals have?

• Prepare/update the data security breach plan – to ensure new rules can be met if needed.

• Audit your consents – are you lawfully processing data? Will you be permitted to continue processing data under the GDPR?

• Set up an accountability framework – e.g., monitor processes, procedures, train staff.

• Appoint a DPO where required.

• Consider if you have new obligations as a processor – is your contractual documentation adequate? Review contracts and consider what changes will be required.

• Audit your international transfers – do you have a lawful basis to transfer data?

As May 2018 draws inexorably closer, companies need to start thinking about compliance before it is too late to avoid being made an example of. As the old adage goes: those who fail to prepare, prepare to fail.

The below market commentary was written by Eric W. Noll, Convergex CEO.

MiFID II, an upcoming piece of legislation from European Union regulators, upends the traditional linkage between trading commissions and investment research in ways both the money management and brokerage industries have yet to fully understand. It will force both the explicit pricing of sell-side research and the defense of those expenses to asset owners by money managers. Moreover, while this is an EU directive, we expect many global asset owners to eventually embrace its core principles of explicit pricing and transparency. By virtue of our market leadership in the Commission Sharing Agreement business through Westminster Research, we stand ready to offer solutions and act as a guide to our money management clients as they face these new challenges.

"Half the money I spend on advertising is wasted; the trouble is I don't know which half." That century-old quote from John Wanamaker, one of America's most famous merchants, is as true today as it was in his time. Every business knows they have to advertise to attract new customers and retain old ones, but even in the Internet Age the advertising game remains – at best – an imprecise science.

There is a close analog living on Wall Street: the value of the sell-side equity analyst. Every Director of Research knows that half of their firm's analysts generate most (if not all) of the aggregate profitability of their team. Sometimes that is because the analyst in question has a history of great calls. Other times, it is because they run the best-attended conference in the sector. In still other instances, it is just "right place, right time" - a solid analyst who happens to cover a sector that has gotten hot of late.

On the investment management side of the business, Wanamaker's adage has similar relevancy when it comes to the research these asset managers purchase from those brokerage firms. Half – if not more – of the content a portfolio manager/analyst receives from the Street is perceived to have little-to-no value. Sometimes that perception is based on the principle that it is simply not value-added work, and sometimes that the research addresses a company or sector that is currently out of favor. That is an important difference of course, even if it does not change the 50/50 calculus.

This is all about to change, and the catalyst comes from the European Union with its Markets in Financial Instrument Directive (commonly called MiFID II). Set to take effect on January 3^rd 2018, it requires investment managers to rethink how they pay for brokerage firm research. No longer will they be able to bundle commission payments for trading execution and research services. After January 3^rd 2018, if they want to purchase brokerage firm research, there are just two options:

1. Pay for it in cash from the earnings of the money management business itself.
2. Set up a Research Payment Account (RPA), to be funded either with an explicit fee charged to the investment firm's clients or with commissions explicitly carved out of trading executions. The RPA will need to be structured strictly in accordance with the new regulations as well as require the asset manager to create a research budget for the year ahead, apply appropriate quality assessments to the research being consumed and report research expenditures to its clients on both an ex-ante and ex-poste basis.

That might all sound innocuous enough, but once you think through the ramifications it becomes clear that big changes are afoot. For example:

• Under either approach, asset managers will want to know exactly what they are paying for and how much it costs. When was the last time you saw a hot-off-the-press research report from a top tier analyst with a price tag printed on the cover? Never. But under MiFID II it is coming. And coming fast.

• If an asset manager chooses to use an RPA, they will have to budget their research expenses (and stick to that budget), actively manage those expenses and provide transparency to the asset owner about what resources they use and how much they cost.

Take a moment and consider the ramifications of these changes. Here are just a few novel questions and issues they raise:

• What is the process to develop a research budget? Do you just look at trailing expenses? Or do you try to forecast future market volatility and anticipated sector correlations, which may provide more investment opportunities but also require the purchase of more resources? And how much do you allocate to macro research (which has been a must-have over the last decade) versus stock-specific work (because correlations now appear to be in secular decline)? Outperforming a benchmark is tough enough; now, you might need to forecast which resources you will require before it is obvious that you will need them.

How does the sell-side develop a service menu to help their clients budget their research spends? Over the decades, brokerage firms have refined a dynamic pricing model that enable them to essentially charge different prices to different customers for the same product, all the while looking to capture every bit of potential revenue.  Now, clients will want to know exactly how much a report or an analyst visit or a conference will cost. It's like going from a family-style buffet restaurant to a dining establishment with a la carte pricing.

• While this is currently an EU-only mandate, how will it change both the creation and consumption of research in the US and elsewhere? Once asset owners see the process start to take hold in Europe, they may well ask their managers in other markets for similar disclosures. MiFID II could well become a global standard for research pricing and disclosure, even if the actual payment mechanisms (commissions in the US, for example) remain unchanged.

While US based asset managers may not necessarily have to comply with MiFID II, it is important to emphasize that we anticipate this directive will ultimately have a global impact as it is now virtually impossible to contain regulation within geographic boundaries. As global managers do business with European asset owners, they may ultimately make a decision to adapt their current procedures to give them the operational capacity to respond to the MiFID II Directives and err on the side of caution.

Now, if you want a playbook for how all this looks, we have it. Our Westminster Research Associates business has been around for 20+ years, helping clients with exactly the sort of challenges they will face with MiFID II. For example:

• Westminster processes hundreds of millions of dollars every year in payments on behalf of clients. Every single bill they pay has an explicit price for the research resources used by our clients. Every research provider you can imagine accepts these payments, from top tier brokerage firms to data providers and bespoke resources that may only have one or two clients.

• The Westminster team also acts as consultants to our base of 700+ clients, helping with everything from uncovering hard-to-find research resources to efficient bill-paying and CSA account reconciliation. In a post-MiFID II world, this allows clients to see the full landscape of resources and better understand what is a "fair" price for the services they receive.

• Westminster is currently enhancing its market-leading systems and processes to dovetail seamlessly with MiFID II's concept of a Research Payment Account. In fact, Westminster has been preparing for the MiFID II Directives since early 2016 and has the ability to work with any software provider to offer a comprehensive RPA solution to its clients. The spirit of both the current CSA paradigm and the RPA approach are sufficiently similar that we believe the solutions offered by Westminster can add considerable value as clients make the transition to the new regulations.

In summary, MiFID II may be an EU regulation but it will almost certainly change broker-provided investment research around the world. We see that as a positive development because with greater transparency will come more accountability and, ultimately, a more efficient research marketplace. Clients will get more of what they want – truly differentiated research that helps them perform – while tracking what that resource costs and explicitly evaluating its cost and benefits.

Will this be an easy transition? Of course not, but we are focused on making all of the necessary changes to our business model to meet the MiFID II requirements that will enable our clients to respond effectively to the new environment. The quote with which we started this note mentioned that half of all advertising is wasted. It could well be that half of all broker research is unwanted. Only time will tell. But with MiFID II on the horizon, we are on the road to finally determining which half is truly valuable. And that is a journey worth taking, both for brokers and for asset managers.

(Source: Convergex)