The firewall that Wall Street hoped would protect its U.S. stock and bond analysts from tough European rules is starting to crack.
At issue are European Union regulations that took effect last year that forced banks to start charging clients separately for trading and research, rather than bundling the services into one bill. In October 2017, U.S. brokers scored a major win when the Securities and Exchange Commission issued a legal reprieve that at least temporarily kept the rules from spreading to America.
But in the ensuing months, some of the brokers' most important customers — big fund managers — have grown frustrated with having to pay a single tab for everything in the U.S. and then write multiple checks in Europe.
At the same time, money managers are facing pressure from their own clients, who ultimately pay the fees that brokers charge mutual funds.
For instance, the EU's new rules have prompted U.S. pension plans that invest through BlackRock (BLK), T. Rowe Price, Capital Group and other firms to increasingly question whether combining costs for securities trading and analysis leads to price opacity that lets Wall Street overcharge for research. Another concern among state pension boards is that they are paying for analysis that isn't even benefiting them.
Now, a group representing some of the world's largest money managers has issued perhaps the biggest threat to the way U.S. brokers have long done business. Last month, the Securities Industry and Financial Markets Association's asset management unit signaled that it wants the SEC to let brokers accept payments from U.S. clients just for research. If such a change took hold, it could force stock and bond strategists to eventually prove that they can bring in revenue on their own, rather than being subsidized by trading fees.
"Investors would be best served if asset managers were able to choose a payment arrangement for investment research that makes sense based on the individual circumstances," the Sifma group wrote to SEC Chairman Jay Clayton in a letter that hasn't previously been made public.
The SEC declined to comment on the letter.
The request is just the latest example of how Europe's revised Markets in Financial Instruments Directive, or MiFID II, risks reshaping the global research industry. If the regulation is adopted in the U.S., securities firms could face tough decisions about whether to cull the ranks of their market strategists. In Europe, the impact has been clear, with brokers' earnings from equity research falling an estimated 20%, or $300 million, according to Greenwich Associates.
Regulations governing brokers are complicated. Wall Street argues firms are all but prohibited from selling stand-alone research to U.S. customers unless brokers are also registered as "investment advisers." That distinction is important because the SEC requires that investment advisers give extra protections to their clients.
The issue became the focus of an intense lobbying campaign prior to MiFID II's implementation, with brokers telling the SEC that if they took payments from European clients for research they were at risk of being punished by the U.S. regulator for engaging in conduct that was limited to investment advisers.
The SEC ultimately said in October 2017 that it wouldn't sue brokers as long as they only sold stand-alone analysis in Europe. The relief didn't apply to transactions involving U.S. customers, making it hard for Europe's changes to spread to America.
That's why the SEC's ruling was seen as a firewall that insulated Wall Street from MiFID II. Still, the relief expires in July 2020, which the SEC said would give it time to study the market and then possibly allow for more sweeping changes.
But some money managers are indicating they don't want to wait.
Earlier this month, Capital Group, which manages more than $1.7 trillion, said in a statement that it would reimburse clients for the third-party research it uses after "having carefully assessed the global regulatory environment and market conditions."
T. Rowe, which oversees about $1 trillion, has told investors that it also intends to pay for research out of its own pocket and is "looking at various options to support a move to this model as quickly as possible," spokesman Brian Lewbart said in an emailed statement to Bloomberg. Sands Capital Management, with about $41 billion, has been footing the bill for outside analysis for more than a year.
Meanwhile, representatives from money-management firms have been meeting with Mr. Clayton and other SEC officials, said two people with knowledge of the matter, who asked not to be named in discussing private business decisions and conversations with regulators. T. Rowe has also told Wall Street banks that it wants to start paying for research separately, one of the people said.
One quandary for the SEC: analysts might have even less of an incentive than they do now to follow the smallest public companies if strategists' research isn't supported by trading fees. Mr. Clayton hinted at that concern in a statement last month, adding that the SEC is eager for industry feedback on the issue.
"It is important to have data and other information about how MiFID II's research provisions are affecting broker-dealers, investors and small, medium and large issuers, including whether research availability has been adversely affected," Mr. Clayton said.
Besides Bank of America, which has moved its analysts into a Merrill Lynch unit that is a registered investment adviser, most banks have resisted making changes. But there are signs they are starting to feel pressure.
Industry officials have met with the SEC to discuss whether brokers should be allowed to sell stand-alone research to U.S. clients without running afoul of the agency's rules, said two people familiar with the matter.
Tyler Gellasch, who runs a trade group whose members include the California Public Employees' Retirement System, predicts it's only a matter of time before the U.S. goes the way of Europe because that's what pension funds want.
"The cat is out of the bag," said Mr. Gellasch, the executive director of the Healthy Markets Association.