Making MiFID II Work

The New
Execution
Champions
Part 3: Unbundling Research
The Future Corporate Bond Dealing Desk Post MiFID II

January 2018

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This paper is part of Making MiFID II Work—our comprehensive
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 The New Execution
Champions
Part 3: Unbundling Research

The Future Corporate Bond Dealing Desk Post MiFID II

January 2018
The New Execution Champions - Part 3: Unbundling Research
Executive Summary
The industry is on the brink of a new evolution in the provision of liquidity and execution performance. Wholesale
automation of buy-side bond dealing desks has arrived, but its successful implementation will require new
execution champions to step up to the fore to ensure that the asset management industry, as well as end
investors, can fully benefit. The following is the third report in the series, focusing on how trading will shift as the
provision of research is unbundled from execution services.

Key Facts
1. Sell-side brokers have traditionally been compensated through spread capture, but firms now need to
provide a separately identifiable charge for research and execution. This is proving challenging for many;
66% are still in discussions with their brokers over the cost of research.
2. The full impact across the industry has yet to be felt as for just over half of the respondents
unbundling remains a work in progress, indicating further change ahead for traditional buy and sell
side relationships.
3. Portfolio managers have typically “paid” brokers for investment ideas by directing their dealing desks to
send an RFQ for a client order. Change is already underway; just 13% of firms still allow PMs to direct
order flow.
4. The all-important regulatory difference will be to ensure that information from the portfolio manager
can contribute to the execution strategy, but it cannot necessarily dictate the outcome. As such
47% of respondents are now part of a totally segregated dealing desk, ring-fenced from the
research process.

During October and November 2017, global asset management firms representing $13.1 trillion in assets
under management were interviewed to understand how the introduction of new European regulations in
relation to research unbundling and inducement to trade will impact how they trade in corporate bond
markets post MiFID II.

2
Unbundling Research from Execution
Under Article 13 of the Delegated Directive1 firms must now
separate the provision of execution services, transaction
volumes and value from the amount paid for research.
Historically, some portfolio managers have chosen to “repay”
brokers for investment ideas by directing their dealing desks to
send an RFQ for a client order. This will need to change.
Firstly, as per the EU Commission Delegated Directive,
investment firms now need to be able to distinguish between
what constitutes the cost of research and the cost of execution2.
In theory, sell-side brokers have traditionally been compensated
through spread capture, but firms now need to provide a
separately identifiable charge for research and execution, requiring
a switch to explicit commissions.
EU Commission Delegated Directive
April 2016
Article 13
An investment firm providing execution services shall
identify separate charges for these services that only
reflect the cost of executing the transaction. The
provision of each other benefit or service by the same
investment firm to investment firms, established in the
Union shall be subject to a separately identifiable charge;
the supply of and charges for those benefits or services
shall not be influenced or conditioned by levels of payment
for execution services.
Source: https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-
2031-EN-F1-1.PDF

Secondly, there can be no correlation between the transaction volumes “Unbundling research will change the
executed by a broker on behalf of a portfolio manager and any “discount” sell side; it doesn’t matter whether you
applied to the research3. This is pushing buy-side firms towards are MiFID, UCITs or AIFMD—this is how
firms will have to manage their
centralised dealing desks to ensure they do not fall foul of any
business going forward.”
“inducement to trade”.
Medium-sized European Asset Manager
The challenge is that the construct of a fixed income trade has
traditionally involved the portfolio manager and information on liquidity
flows. Many firms still rely on order management system technology for
“We are now 100% unbundled but
trade executions and, as such, traders have limited market information.
some of our fixed income PMs are
Therefore, when portfolio managers suggest Firm A or B, they also finding it hard to accept.”
provide dealing desks with low-level market colour; which is invaluable
Large Global Asset Manager
information in the absence of accurate valid data accessible via execution
management system (EMS) technology.

The all-important regulatory difference will be to ensure that information “We are implementing a centralised
from the portfolio manager can contribute to the execution strategy, but it dealing desk, and our PMs will no longer
will not necessarily dictate the outcome. This will require considerable be allowed to trade.”
internal discipline to ensure that PMs do not continue to attempt to Medium-sized UK Asset Manager
influence execution outcomes, particularly given the requirement for
firms to implement compliance monitoring of best execution policies.
This includes putting in place effective and appropriate channels “to “If the PM tells me ‘Listen, I happen to
ensure that the results of ongoing execution monitoring are escalated to senior know that XYZ bank have an axe in
management and/or relevant committees”.4 this’, I will include them in my enquiry,
but if I can improve, I will trade away;
best ex sits with me.”
Medium-sized UK Asset Manager

1
https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2031-EN-F1-1.PDF
2
https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2031-EN-F1-1.PDF
3
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf
4
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf

3
For some firms, it is only through the introduction of a totally segregated “The PM may know where the axe is,
dealing desk that they are able to keep their PMs at arm’s length and and that’s valuable information we can
ensure best execution is correctly followed rather than fudged. The use, but it cannot dictate the execution
opportunity to cross natural flow inside the bid/offer spread is always the outcome. If the dealer finds a better
price, he needs to trade away.”
optimal “best execution” given the reduction in market impact and
transaction cost savings, rather than the broker being given the Large Global Asset Manager
opportunity of a “last look” and reducing the spread by a fraction.

Exhibits 1 and 2
Are your PMs still able to direct order flow? / To what extent are you unbundled as an organisation?

Source: Liquidnet Research

Forty-seven percent of respondents now operate fully segregated dealing “There is no legitimate reason why a
desks. Just 13% of respondent firms still allow portfolio managers to PM should be able to direct a trade, and
influence how orders are executed (see Exhibit 1). This segregation of we now have the buy-in of senior
trading from portfolio management will accelerate throughout 2018, as for management to make this happen.”
just over half of the respondents “unbundling” research remains a work in Large Global Asset Manager
progress (see Exhibit 2). This will impact not only how research is provided
and priced, but also how execution counterparties are selected, liquidity is
formed and performance is measured.

Progress internally is not always smooth, with cultural changes needing to “There are occasional trades but these
occur for firms to recognise the extent of change required to fully must be flagged so that we are aware
unbundle. The recent reminder by the UK regulator that the responsibility the PM has had involvement, so we can
remains with fund managers to prove they are paying an appropriate price make sure they are conflicted.”
for research5 echoes previous guidance from ESMA: the regulatory burden Large Global Asset Manager
of proof will be more onerous for firms that choose to receive execution
and research services from the same provider6.

5
https://www.fca.org.uk/publications/multi-firm-reviews/firms-fail-meet-expectations-use-dealing-commission
6
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf

4
One method of managing the potential conflict of interest in delivering best “Our problem is that the relationship is
execution is to ensure that trades with any portfolio manager involvement still owned by the PM. We still require a
are flagged and monitored. This will evidence that the decision-making cultural shift in behaviour which is
process to deal was based on the appropriate execution policy and happening, just very slowly. PMs still
think that getting two or three
procedures, rather than the provision of an investment idea.
competing prices, and picking the best,
is best execution. We know it’s just not
what the regulator expects.”
Medium-sized Asset Manager

5
Paying for Research: The Five Elements
Firms are required to have a clear methodology to
establish what they expect to pay providers for research
before they receive and consume services. For the majority
of respondents this is still very much a work in progress.
Only a quarter of respondents have been able to establish a
pricing regime for research with their brokers (see Exhibit
3). This is important, because without a clear pricing regime
in place, firms may not accept research from the sell side.
Widespread disparity in the pricing of broker research
makes the process of establishing a pricing regime
complicated, coupled with the issue of adjusting to
continual changes to service offerings as the sell side fights
to maintain its market share.
Evaluating the cost of research provision is also
complicated. Once the overall budget is agreed,
establishing how research is consumed internally, and
therefore who should pay, has additional challenges when
considering macro-economic research in particular,
compared to equity research. In addition, equity research
will be consumed alongside fixed income research for
corporate bond investments. Establishing internally who
pays for what and when is still eluding some firms.
There are five key elements that asset managers will have
to address to unbundle their research costs from their
execution costs. Firms will need to establish:
1. What research they value;
2. Whether it is of minor non-monetary value and
therefore whether it should be paid for;
3. What price to pay;
4. Who to pay; and
5. How to pay.
6
Exhibit 3
Have you established a pricing regime with your
broker on the provision of research?
Source: Liquidnet Research
ESMA Q&A Investor Protection
November 10, 2017
Inducements – Question 9
Fixed Income Research
ESMA acknowledges that the current lack of established market
practices and mechanisms for investment firms to pay for FICC
research separately from execution costs may limit certain
operational arrangements firms can adopt to comply with
Article 13. Primarily, FICC markets do not currently have explicit
execution commissions and mechanisms that allow research
charges to be deducted alongside transaction fees. ESMA notes
that firms still have the option to pay for research themselves,
or using a research payment account that is funded by a direct
charge to the client, which could be facilitated by a third party
such as a depositary or custodian, rather than alongside a
transaction. Given the commonalities between some forms of
written macroeconomic and FICC research, ESMA considers that in
some cases written FICC research could be capable of being
priced and paid for through a subscription agreement (see Q&A
8). However, firms would need to document how they arrive at
their pricing structures and ensure there is no inducements
risk in order to comply with Article 13(9). There also is the
option for research providers to make FICC material available to all
investment firms or the general public,
or for firms to receive FICC material it if commissioned
and paid for by a corporate issuer or a potential issuer. In this case,
the analytical input will qualify as a minor
non-monetary benefit as set out in Article 12(3)(b) of the
Delegated Directive.
Source: https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2031-
EN-F1-1.PDF
What is Research?
For many respondents the main challenge is still establishing
what kind of sell-side interaction constitutes research to be paid
for, and what can be considered minor non-monetary, and
therefore consumed for “free”.
ESMA takes the view that if the market commentary is limited and
of such scale that it is unlikely to influence the firm’s behaviour
and investment decision, then it can be considered as a minor
non-monetary benefit. By comparison, a detailed research report
or conversation with a research analyst cannot be considered as a
minor non-monetary benefit, irrespective of whether it is provided
by the research department or the sell side trader7.
This should not prevent communication between trading desks
around order execution—for example, on available liquidity or
recently traded prices—as this falls under the “execution service”
EU Commission Delegated Directive
April 2016
Recital 28 – What is Research?
“Material or services concerning one or several financial
instruments or other assets, or the issuers or potential
issuers of financial instruments, or be closely related to a
specific industry or market such that it informs views
on financial instruments, assets or issuers within
that sector.”
“Material or services that “explicitly or implicitly
recommends or suggests an investment strategy and
provides a substantiated opinion as to the present or
future value or price of such instruments or assets, or
otherwise contains analysis and original insights and reach
conclusions based on new or existing information that
could be used to inform an investment strategy and be
relevant and capable of adding value to the investment
firm's decisions on behalf of clients being charged for
that research.”

which is paid for separately. However, if the sell-side trader is

providing analysis with market colour, this would be considered
research and would need to be paid for as a separate service. Source: https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-
2031-EN-F1-1.PDF

Whether or not analysis can be considered research has to be

considered against the criteria set out in Recital 28: Does the research in
question inform “views on financial instruments, assets or issuers within that “If a desk analyst keeps running an
sector or market,” and whether “this material or service explicitly or implicitly engine to see if the bond is cheaper or
more expensive, that’s a minor non-
recommends or suggests an investment strategy … [or] could be used to inform an
monetary benefit. But if the PM is in
investment strategy”.
discussions with an analyst who
suggests a SELL strategy - that’s
In ESMA’s view, most macro-economic analysis is likely to suggest an research, and they can have no
investment strategy unless it is sufficiently general to fall outside the influence in the execution outcome.”
definition of research. If it is considered research, it may then be received
Medium-sized UK Asset Manager
(and paid for) by an investment firm. If not, it does not automatically classify
as a minor non-monetary benefit, and portfolio managers and independent
advisors would need to make a commercial decision either to pay for it or not
accept the service8. “We are currently being asked to go
to certain people. If research is "zero"
If a buy-side firm decides not to accept the research, they are then obligated we will be under even more pressure to
to take “reasonable steps to cease receiving it or avoid benefitting from its go to certain houses. They will say its
content”9. ESMA suggest “automatically blocking or filtering certain zero, but then the PM will be pressuring
senders/materials, and/or requesting a provider to stop providing research, us to trade with them so he can get the
and/or using the compliance function of the firm to monitor, assess and ideas still.”
determine whether the material can be accepted before it reaches those Medium-sized UK Asset Manager
parts of the firm that would make use of it”10. The buy-side firm is

7
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf
8
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf
9
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf
10
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf

7
responsible for stating that it is not induced to trade by receiving research or alternatively it is paying for the
research appropriately.

ESMA also notes that where a sell-side firm provides research and execution services, merely providing the
research for free “would not meet the obligation on them to price services separately, and ensure its supply does
not potentially influence the execution services they supply. On that basis, firms should have systems and
controls in place to enable them to cease providing unsolicited research”11.

11
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf

8
What Price to Pay
The price of fixed income research appears to be in continual free fall, with “You get the impression that the longer
you hold off, the better you will be. We
several participants either still unable to agree a price with brokers or unsure
have thirty traders around the globe.
what the regulator will believe is an acceptable price for research.
Unbundling and rising costs mean we
need to iron out synergies wherever we
Many firms were unaware of just how much research was being consumed can. Our CIO is looking at this right now,
within their organisation; nor did they know the value that the sell side the cost of research has to come down.”
attached to the provision of the research. As more firms have moved towards
Large Global Asset Manager
paying for research directly, CIOs are becoming increasingly involved in the
management of research bills, as asset managers endeavour to plan their
requirement for external research with the fee structure proposed by brokers.
“The cost of research seems to be a
As firms work through broker lists, they are splitting out those brokers where race to zero.”
they need to maintain minimal access to avoid any inducement risk, and those Large Global Asset Manager
which are "must-have" research houses and they expect to pay a premium.

“Click & read” research offerings appear to be normalising at around $10k as

an entry point for most major banks, offering unlimited access to both “You get a number on Monday and its
economic and strategic research. In contrast, bespoke analyst interaction is half the number by Friday. We are
getting closer to the real figure, but we
less conformist, with some brokers insisting that their research is worth a
are not there yet.”
six-figure sum.
Medium-sized UK Asset Manager
The price of broker offerings may differ for similar services, with some even
offering research for free. This not only makes it challenging for the buy side
to establish what a fair price should be, but many on the buy side are also “The PM might want access, but once
concerned about how the regulator will view this in terms of inducements. they know the figure, they think again.”
Other brokers are offering equities research incorporating fixed income in a
Medium-sized UK Asset Manager
last-ditch attempt to retain market share. This seems an unlikely successful
approach from a regulatory perspective. In addition, the buy side is also
increasingly scrutinising whom it is paying and what it is receiving as a
result—with a growing shift to selecting external research from a reduced “Broker X were at 10k now they are $5,
core list for specific specialisms and internalising research wherever possible. yet they can’t provide it for free, and
Broker Y are still saying their research is
worth $100k. It is hard to establish
what a fair price should be.”
Large Global Asset Manager

“We have seventy investment desks

globally and they all have a different
way of interacting, but we have spent
the last couple of years internalising
research. If we find we are relying on
someone external too much, we just
hire them.”
Large Global Asset Manager

9
How to Pay
While ESMA acknowledges that FICC markets do not currently have
explicit execution commissions and mechanisms that allow research
charges to be deducted alongside transaction fees, firms are still
subject to rules on inducements.
As such, the provision of research must be paid for separately to
ensure it cannot be regarded as an inducement, either directly via
the P&L, or from a separate research payment account (RPA)
funded by a specific, agreed research charge to the client.
According to ESMA’s Q&A on Investor Protection, written FICC
research can be priced and paid for through a subscription
agreement12. However, regardless of what the sell-side proposes in
terms of research offerings, firms would need to document how
they arrive at their pricing structures to protect against any risk of
inducement, in compliance with Article 13.
ESMA Q&A Investor Protection
November 10, 2017
Inducements – Question 10
Fixed Income Research
ESMA expects portfolio managers to have robust systems
in place to ensure that decisions on the procurement of
research are clearly documented, and are taken separately
and distinctly from decisions on the choice of brokerage
and execution services subject to relevant best execution
requirements. This means that firms should carefully
consider whether their policies and research procurement
systems are designed to minimise any conflict of interest
that may arise. Portfolio managers should be particularly
aware of such risks when purchasing research alongside
execution services. Doing so in a way that is compliant with
MiFID requires severing the link between transaction
volumes and value and the amount paid for research inputs
(Article 13(2)(b) of the Delegated Directive).
Source: https://www.esma.europa.eu/sites/default/files/library/esma35-
43-349_mifid_ii_qas_on_investor_protection_topics.pdf

As part of establishing a research payment account, firms must set

and regularly assess a research budget and the quality of the
research purchased “based on robust quality criteria and its ability to
contribute to better investment decisions”13. Budgeting for research should “We are committed to P&L, but how it is
take place at the outset of the research procurement process in order to going to shake out is still difficult to see.
determine the level of the research charge in the best interest of clients. It Brokers are now offering to provide
should be an ex-ante estimate of forecast expenditure for research costs research for free. That looks gimmicky
to me; I think the regulator might have
based on the type, level and quality of service provided, which then can be
something to say in terms of
charged to portfolios with similar strategies under management.
inducement. But what is the right
value? What should it be?”
Once the budget is set for a specified period, Article 13(6) of the Delegated
Directive requires firms to monitor the allocation of the budget to third-party Large Global Asset Manager

research and ensure it is used in the best interest of the firm’s clients.
Research budgets then need to be regularly reviewed to evaluate the quality “I am not sure that one broker offering
of the research purchased and to improve their future procurement decisions research at $100k or another offering
and payment levels. research at $2k or $5k will work. It’s
the way we look at our pricing that the
Portfolio managers must also have a robust system in place so that decisions regulators will challenge.”
on research procurement are documented and separated from any decisions Large Global Asset Manager
on the choice of brokerage and execution services subject to best execution
requirements.

Firms could receive FICC material if it is commissioned and paid for by a

corporate issuer or a potential issuer, as the analytical input will qualify as a
minor non-monetary benefit as set out in Article 1214.

12
https://www.esma.europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_protection_topics.pdf
13
https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2031-EN-F1-1.PDF
14
https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2031-EN-F1-1.PDF

10
Conclusion
While unbundling has been underway in equities for many years, the concept “We will be paying for global access:
of establishing a separate research and execution payment remains an alien P&L, bottom line from the fixed income
concept in fixed income, as it is, quite simply, not how much of the corporate wallet. But it is separate from who pays
bond market operates today. A PMs involvement has historically been very for what, and the budget in fixed
income is much lower than in equities.
influential in where and how the execution of orders has occurred. Going
We are getting lots of research, but we
forward, under MiFID II, this clearly will need to change. Sell-side can’t pay zero, and we should be paying
organisations have only added to the confusion by delaying pricing structures for research.”
and offering price points that the regulators may perceive to be an
Large Global Asset Manager
“inducement” to trade.

However, there is a difference between being induced to direct a trade and offering up information which can
then be accepted or rejected by the dealing desk. There needs to be a clear segregation of duties for firms to be
able to benefit from additional valuable information, but still ensure that the dealing desk has the ultimate say on
where orders are executed to deliver “best execution”. The cultural and behavioural change for fixed income
trading is so great that for some firms to achieve compliance within the timeframe required will necessitate a
total segregation between PMs and the dealing desk.

There also needs to be a clear change in approach of understanding that “best execution” does not equal the
cheapest price. The opportunity to cross natural flow is optimal given the reduction in market impact, rather than
a broker having the opportunity of a “last look” and reduce the spread by half a basis point. The introduction of
new technology and methods of trading, as well as the quantitative evidence this provides, will be able to provide
the facts and figures to change the traditional mindset.

However firms ultimately choose to implement “unbundling”, dealing desks now have the opportunity to deliver
enhancements to firm’s investment strategy. Wholesale automation of buy-side bond dealing desks has arrived,
but its successful implementation will depend on the rise of independent execution champions to truly evidence
best execution.

11
12
About the Author
REBECCA HEALEY
Head of EMEA Market Structure and Strategy
rhealey@liquidnet.com
+44 207 614 1607

Rebecca is considered to be one of Europe’s leading industry voices on

market structure, regulatory reform, and financial services technology. She
has authored a plethora of qualitative research reports and commentary
covering the impact of market regulation on all asset classes, changing
market structure and developments in dark pools, HFT, and surveillance.
She joined Liquidnet in July 2016 to use her 20 years’ experience to
collaborate and deliver research and insights for both the European
equities and fixed income markets. Rebecca is also Co-Chair of the FIX
Trading Community’s EMEA Regulatory Subcommittee dedicated to
addressing real business and regulatory issues impacting multi-asset
trading in global markets. She has held prior roles at TABB Group, Incisus
Partners, the British Embassy in Bahrain, Credit Suisse, Goldman Sachs
International and Bankers Trust International.

To stay up to date with the latest information and to get more of a

deep-dive into the detail, please contact mifid2@liquidnet.com.

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