The Tokenization of Research

The update to the Markets in Financial Instruments Directive (MiFID II) is changing the operating paradigm of exchanging client commissions for execution and research by, among other things, requiring asset managers to: (1) clearly delineate the execution cost versus the research cost on every trade; and (2) assign value to each research piece consumed. The European requirements do not align with practices in the U.S. governing exchanging execution for research, as permitted by Section 28(e) of the Securities Act of 1934.

Even with limited exemptive relief granted by the SEC through the ICI, SIFMA-AMG and SIFMA (through July 2020) no-action letters, brokerage firms and asset managers active on both sides of the Atlantic are challenged by having to comply with two different sets of regulatory requirements, along with the need to create new business models that generate sustainable levels of profitability. There is a need for fundamental change.

Impact of MiFID II on Research in the U.S.

MiFID II is a European regulatory act whose rules, which go into effect on Jan. 3, 2018, create new requirements for trade execution and commission management, including:

• Assignment: A value must be assigned for each piece of research received by asset managers.
• Evaluation: Clear and published research procurement, valuation, and tracking policies must be in place.
• Payment: Research must be paid for.
• Delineation: A delineation of execution vs. research cost is required for every trade.

Mechanisms to comply with MiFID II’s requirements include:

• P&L: An asset manager may elect to absorb all research costs.
• Research Payment Accounts: Client-funded Research Payment Accounts (RPAs) may be created to govern the use of commissions for research within a pre-determined annual budget. However, once an asset manager’s annual RPA research budget is consumed, an asset manager must obtain approval for additional research payments or trade at execution cost only.

Section 28(e) is a legislative act of Congress that creates a Safe Harbor that governs trade execution and commission management in the U.S., including:

• No Obligation to Use Lowest Cost Execution: An asset manager is not required to automatically route order flow to the lowest cost execution provider, as the quality of research provided by brokerage firms may be included in the definition of Best Execution.
• **Soft Dollars Are Permitted:**Soft dollars may be included in commission costs and allocated to pay for research. There is no requirement to delineate execution vs. research costs in a trade.
• No Mandated Limits on Commission Budgets: There are no mandated limits or annual budgets governing the use of commissions by an asset manager beyond 28(e)’s language directing “if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage.”
• No Valuation Requirement: There is no requirement that a piece of research be assigned a monetary value.
• Registration: Brokers do not have to be registered as Investment Advisors (IAs) to receive commission payments for research. However, they must be registered as IAs to receive direct research payments (including CSA payments from other brokers).

The European MiFID II rules and the U.S. 28(e) legislation create dissonance for American and European brokerage firms and asset managers with trading operations and investment portfolios on both sides of the Atlantic. The two systems differ in significant ways, with a possible outcome that American firms may feel obligated to forsake the 28(e) Safe Harbor and conform their global operations to the MiFID II requirements due to the:

• Cost and complexity of maintaining multiple systems to perform the same function; and
• Likelihood of inadvertent MiFID II violations.

Regulatory and Financial Impact of MiFID II

Satisfying one set of regulations or the other is less than optimal as a long-term solution when both systems clearly offer desirable benefits. One path to MiFID II compliance is the absorption of all research costs by asset managers (referred to as “P&L”). This approach could have a significant impact on an asset manager’s financial results. London-based Frost Consulting examined the impact of MiFID II on asset managers in the U.S. under the assumption that asset managers absorb the cost of their investment research. Frost Consulting estimated asset managers would experience a drop from a 30% operating margin to a 16% operating margin, equating to industry-wide profits of $10.7 billion dropping to $5.7 billion.

Meanwhile, the financial impact of MiFID II on brokerage firms could also be severe. Greenwich Associates interviewed 223 U.S. equity portfolio managers and 321 U.S. equity traders between November 2015 and February 2016. Greenwich estimated the annual pool of cash equity commissions paid to brokers on U.S. equity trades was $9.65 billion, down more than 30% from its 2009 peak. The data suggests that the breakdown between execution and research is 45% to 55%, or roughly $4.35 billion for execution and $5.30 billion for research. A concern is that, upon the implementation of MiFID II, the total research spend may drop in a significant fashion as P&L and RPA-driven asset managers consume less research.

In turn, Frost Consulting concludes that major global investment banks have slashed their equity research budgets by more than half, from a peak of $8.2 billion in 2008 to $3.4 billion in 2017. McKinsey projects, in anticipation of MiFID, the top 10 banks are expected to cut research budgets by another 30 percent in the near term.

Thus, given the challenges created by and the disparities between the European and American regulatory requirements governing execution and research payments, it is desirable to find a single comprehensive solution that optimizes benefits and complies with both regulatory environments, in essence:

• Delineates the execution vs. research cost in every trade;
• Assigns value to each piece of research received by asset managers; and
• Enables the payment and consumption of research via execution without subsidizing one for the other.

Some have concluded that the regulatory differences between MiFID II and 28(e) make such a solution impossible. What remains is a choice to adopt MiFID II on a global basis, maintain two distinct operations in the US and Europe, or stop doing business in Europe. This is, in effect, a Hobson’s choice.

Digital Technology and New Business Practices

We live in an age of tremendous digital transformation. MiFID II may create the impetus for innovation to address these challenges in a comprehensive manner that is positive to all participants. Recent attempts at dealing with the conflicting regulations have focused on one set of regulations rather than both, thereby exacerbating the divide between the two sets of regulations. New digital technologies, including tokens, smart contracts, blockchain and platforms, are creating capabilities that were unforeseen only a few years ago. Simultaneously satisfying these regulatory challenges and capitalizing on the benefits provided by both regulatory environments may be possible, but only by leveraging innovative technology and embracing new payment and consumption methods; such as those which incorporate tokens, smart contracts, blockchain and platform technology. Such a platform values research and execution through different methodologies and applies fees for each in different units.

A platform that contains currency and non-currency payment mechanisms not only provides participants the opportunity to capitalize on the advantages inherent in the respective diverse regulatory environments, but also introduces a network that:

• Increases the distribution universe for research providers;
• Increases the supply of research for research consumers; and
• Builds a competitive and sustainable environment for research provision and consumption.

Such a platform would create new positive economic benefits for consumers of research, brokerage and asset management services.

In Part Two, we examine the structure and operations of a token, smart contract and blockchain-based research platform for U.S. equity research that incorporates Section 28(e) practices in a post-MiFID II environment.