US brokers brace for the worst as SEC’s ‘no-action’ letter on MiFID II lapses today

Rick Steves

“Some US brokers may lose out on European revenues, and many European asset managers will have less choice and less access to diversified, niche US research. Further regulatory alignment in the research market may be likely with changes in European rules in the next year or so, but not in time to fix this mess.”

The Securities and Exchange Commission’s has allowed the protections provided by its No-Action Letter on MiFID II to lapse, despite a unanimous vote within the House Financial Services Committee in the US in May 2023, to ‘direct’ the SEC to extend the protections once again.

The move was long awaited as, in July 2022, the SEC gave notice that it would allow the ‘no action’ letter to lapse in July 2023, believing that there were sufficient viable solutions, and sufficient time for asset managers to prepare for the rule change.

Why the SEC ‘no action’ letter on MiFID II

The ‘no action’ letter was designed to address a disconnect between the US and EU jurisdictions when it comes to market research following the implementation of MiFID II in 2018.

When this EU regulation came into effect, Europe unbundled trading and research, forcing almost all asset managers to pay for research in cash only. The regime in the US is the direct opposite of this approach, as the SEC requires research to be paid in commissions alongside a trade and doesn’t allow for research to be paid in cash.

The ‘no action’ letter acts as a ‘carve out’ that allowed European asset managers to pay US brokers in cash. However, in July 2022, the SEC stunned the markets by giving notice

There is widespread belief that the SEC’s decision to allow the ‘no action’ letter to lapse will throw the research market into chaos for many institutions and research providers.

“Will the SEC tolerate these cash payments after July 3rd? No one knows”

Among the leading voices against the SEC’s decision is Mike Carrodus, CEO of Substantive Research, the research discovery and research spend analytics provider for the buy-side, who says it will cause a system-wide chaos for the global research market.

Mike Carrodus, CEO of Substantive, said: “One issue that has not had much attention so far is the payment for research in cash happening from the US buy side to US brokers, using the No Action relief as cover. It is predominantly between smaller firms on either side, but is still significant and doesn’t have a solution. Will the SEC tolerate these cash payments after July 3rd? No one knows, and a number of smaller US asset managers will be exploring setting up new CSA structures this summer as a result.

“Now that the No Action relief has lapsed we will see how buy and sell side firms will be impacted by conflicting regulatory regimes without this important carveout in place. Some US brokers may lose out on European revenues, and many European asset managers will have less choice and less access to diversified, niche US research. Further regulatory alignment in the research market may be likely with changes in European rules in the next year or so, but not in time to fix this mess.

“Many will say that MiFID II caused this problem and it’s not the SEC’s job to fix it for them. However if you look at who has had to deal with the most problems arising from this discontinuation of the relief, it’s actually the smaller US brokers and some of the largest US asset managers.

“Many will be underprepared because they wanted to observe how far Congress could get in applying pressure to the SEC to make this go away, and didn’t want to create internal upheaval unnecessarily. Now some sell side firms will be scrabbling to provide new payment solutions to European clients before they get cut off.”

What are the solutions for the EU-US disconnect

Earlier this year, Substantive Research found in a survey earlier this year that there was no consensus way forward amongst institutions or research providers for the situation because all the potential solutions are allegedly fraught with challenges:

  • The first possible solution is that brokers become registered investment advisors (RIAs), with a number having already done so. Substantive Research says that would allow them to take payments in cash from asset managers, but creates significant operational and compliance burdens and risks, and many brokers have decided that this route is not viable for them.
  • The second solution would be for European asset managers to create structures where they generate commissions from trading, but then reimburse the funds in order to keep research costs away from clients, (buy-side firms say that end investors are now used to not paying for their asset managers’ research costs, and would not currently allow a reversal back into these charges), the firm argues.
  • The third solution would be for European asset managers to pay US brokers entirely in Europe for research consumed in both regions and covering both markets. On the other hand, that would mean that any smaller US brokers that don’t have European entities would be frozen out, as they simply don’t have sufficient amounts of European revenues to justify fixing it all from their side. But from the perspective of European asset managers, losing access to these niche US brokers may be seen as necessary collateral damage in the quest to keep processes simple and straightforward.

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