Financial firms are resisting European Union regulators' plansto make investors pay for fixed-income market research separatelyfrom trades.

Regulators say the research fee is built into the differencebetween the price at which broker-dealers, such as investmentbanks, buy and sell securities, known as the bid-ask spread. Thebanks counter that research is cost-free for clients, so requiringseparate payment would lead to extra costs for asset managerswithout the narrowing of spreads foreseen by the regulators.

“There is currently no pricing mechanism for fixed-incomeresearch,” Andrew Bowley, head of market-structure strategy, EMEA,at Nomura Holdings Inc. in London, said in an interview. “Thesell-side is not charging; the buy-side is not paying: there is noprice,” he said. “We could double or zero out research spend, andthe trading spread on fixed-income instruments wouldn'tchange.”

Regulators argue that separation of research and trading costsis necessary to create a more transparent system whereby assetmanagers take more ownership of decisions on the research they buy,develop a better sense of its value, and become more open to buyingit from other sources.

The European Securities and Markets Authority (ESMA), whichbrings together national regulators in the 28-nation EU, mademarket-research proposals to the European Commission in December aspart of work to implement an overhaul of the EU financial-marketlaw known as MiFID II.

The commission, the EU's executive arm, plans to publish rulesby midyear. The bloc's 28 national governments and the EuropeanParliament will have six months to raise objections. If they don't,the final standards could be issued by year-end and take effect in2017.

For equities research, the ESMA proposals would require changesto the current system whereby asset managers use dealingcommissions to cover the costs of research, effectively passing thecost on to their clients. On the fixed-income side, no suchstraightforward fee exists.

'It is unclear how the ESMA advice could be applied in practiceto fixed-income, commodity, and currency research,'' said ChristianKrohn, managing director of capital markets at the Association forFinancial Markets in Europe, which represents investment banks suchas Nomura, Deutsche Bank AG, and JPMorgan Chase & Co. that arekey research providers.

The plan is “fundamentally inconsistent with the structure ofthe FICC markets where investment managers and their clients do notpay for research,” he said.

Market Size

Under ESMA's approach, asset managers would have the choicebetween a fully unbundled system where they expressly pay forresearch as a separate service, using their own funds, and a hybridmodel where they set up dedicated “research payment accounts”funded by a specific charge to the customer, with the amount ofthis charge agreed on in advance.

The size of the fixed-income research market is also hard toassess.

“Globally, equity research commissions are worth about $20billion a year,” said Neil Scarth, a principal at London-basedFrost Consulting, which advises companies on market-researchissues.

“Fixed-income is a much bigger asset class, but overall there isprobably less research,” he said. “The amount will be less, but itwill be in billions.”

Britain's Financial Conduct Authority, a member of ESMA, saysU.K investment managers pay an estimated 3 billion pounds (US$4.5billion) of dealing commissions per year to brokers, with abouthalf of this spent on equities research.

“Evidence suggests there is much less research on the creditmarkets produced and consumed for fixed income than for equities,and levels of payments for it are likely to be much smaller forthis reason” the FCA said in a report last month.

It's an area that is “more opaque than equity markets sinceresearch is entirely embedded in implicit transaction costs,” theregulator said.

This contention is contested by the banks, which say the bid-askspread is based on a range of market considerations. They also saythe idea that research costs could be included in the spread isinconsistent with best-execution rules that require trades to beexecuted at the best available price.

The bid-ask spread is “competitively formed,” Nomura's Bowleysaid. “It is the existing trading environment and structure whichdrive the spread formation. Those spreads are consistentglobally.”

“Certainly there is a cost involved,” Nicholas Dray ofLondon-based broker Marex Spectron's Independent Research andCommission Management desk, said in an interview.

'Bundled Service'

“Analysts working for the banks don't do it out of the kindnessof their own hearts—they get paid. So there is a cost somewhere,”he said. “It's a bit of a fallacy to say it's free, because theyare cross-subsidizing it somehow.”

Money managers are keen to see a narrowing of spreads if they'reforced to pay separately for fixed-income research, said DanielGodfrey, chief executive officer of the Investment Association,which represents U.K. investment managers.

“If the buy-side starts to pay cash for a product that waspreviously part of a bundled service, then the residual part of thebundle should become cheaper,” he said in an interview last month.While measuring a narrowing of spreads would be difficult, “we willneed to demand that we pay less in spread if we're paying harddollars for research.”

–With assistance from John Detrixhe in London.

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