Why shadows still linger over Mifid II's Cost & Charges regime
April marked somewhat of a fork in the road for asset managers still perplexed by how best to report transaction costs to investors under Mifid II's Costs & Charges directive. The time for further pontification is, however, well and truly over. As of 30 April, new rules mean that the costs for trades actually completed, as opposed to expected, need to be reported under Mifid II.
Put simply, asset managers have to assess the bid/offer spread between two possible prices, and the difference between those prices. The first number is the price of the trade that the fund manager decides to buy or sell at, and the second is the actual price of the transaction which includes tricky to work out implicit costs such as commissions. The problem is that the rules, despite having all the right intentions to deliver transparency to investors, have not really accounted for the challenges involved in calculating implicit costs for the more complex trades.
As such, the way certain asset managers have represented costs has, until now at least, inadvertently made it look as though they have not acted in the best interests of investors. In fact, the methodology they have been using to construct these calculations has often been giving investors a false view of performance. The issue centres around selecting the best calculation methodology to adopt for each trade. Do fund managers go with a bid/offer spread based methodology, or slippage type calculations during periods of higher volatility?
For straightforward calculations on say equities, for example, a slippage methodology can be easily applied. Where difficulties start to emerge is with the more complicated derivatives trades - as it is far harder to work out the implicit costs due to the sheer volume of information required. Take Delta One products as a prime case in point. An asset manager would need around seven or eight more data points before even attempting the calculation. On top of this, the calculation methodology for Delta One instruments is very different from a standard equity trade because it is hard to decipher what is multiplicative and what is additive. Due to the non-specific nature of the original Cost and Charges rules, they do not allow for the intricate nuances of how instruments like this are traded across all the asset classes.
This has, to all intense and purposes, left many asset managers caught between a rock and a hard place. Many still haven't found a way to accurately display implicit costs for highly complicated trades, while at the same time face a race against the time to deliver fully transparent transaction cost reports. And there is immense pressure on some firms, especially those using a larger number of platforms, to meet the regulatory requirements. The answer to this predicament is far from straightforward, but there are some immediate steps the investment management community can take.
In a new era of regulatory oversight in transaction reporting, it is safe to assume that any firm that selects, refines, and deploys the use of data most effectively will be well placed. Similarly, those asset managers that get a better grasp of the intricate detail of the costs associated with their more difficult to execute trades, will also be in a position to report accurately to their investors. After all, the specifics of the highly convoluted derivative trades mean that access to a meaningful benchmark and a more in-depth knowledge of the market structure could hold the key to finally meeting Mifid II's transparency goal for Cost and Charges.
Haider Mannan is a data consultant and regulatory specialist at SIX
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