Wrap Trading and Regulatory Risks in a MIFID II World?

Putting aside our recent election, over the last few years Wall Street has devoted a good deal of attention to the racket being made from across the pond. For PMs, the reality of Brexit and the threat of Frexit and Ita-Leave have them continually hopscotching across markets. In equities trading, for both buy and sell side traders the looming implementation of MIFID II is potentially redefining research compensation and order handling practices.

In terms of best execution, all hands are on deck for MIFID II as they should be. Except, surprisingly, for the SEC who is not actively planning to address potential conflicts to their regulatory regime. Its not that they are willfully turning a blind eye to the potential effects the Euro-centric rules will have on our markets. The SEC remains committed to protect investors and maintain fair and orderly markets. It appears though, for now, they prefer to place their focus on important homegrown issues.

One area of domestic regulatory activity in particular that has been drowned out by the ambient noise from Europe is the monstrous yet often overlooked managed account business. In contrast to mutual funds, managed money or Wrapaccounts allow investors direct access to professional money managers (sub advisors) while still maintaining a private portfolio of individual securities in a brokerage account (with a broker acting as the wrap sponsor). In essence, investors get the best of both worlds. The sponsor provides them with access to best advice across multiple sub advisors with all assets fully transparent and accessible within one account.

Think of wrap as your own personalized fund. Thousands of qualified investors see it that way and have shifted a good portion of their savings into managed accounts over the last decade.

The Rise of Wrap – Size Matters

With its origins in 1970s, the wrap business was a somewhat obscure and niche product that originally served ultra-high-net-worth investors. The financial scandals and market turmoil around 2008 provided an additional spark for managed accounts, as the Madoff Effect inspired massive hedge fund redemptions and wealthier investors sought greater transparency, control and access to their assets. Today, advancements in technology and efficiencies in the industry have reduced the minimum requirements, expanding the reach and customization of wrap accounts to a much more diverse audience who seek greater tax flexibility and tailored investment planning.

According to the Money Management Institute, the wrap business is huge – totaling $4.6 trillion in assets under management in Q3 2016. For comparison, consider that AUM in hedge funds according to BarclayHedge clocks in at roughly $3 trillion.

Given that the aggregate money managed in wrap now outsizes some more high-profile styles of the investing and there has been a rapid migration from the broker dealer model to the investment advisory model, its no surprise the SEC has increased resources to review wrap practices and procedures.

Under Wraps

Unlike traditional brokerage accounts where you pick the securities you want to buy and pay a small fee per transaction (think E*TRADEs $6.95 a trade), wrap accounts essentially charge a flat fee based on the assets under management. Keeping fees simple and transparent is what attracts investors. However, additional costs can be incurred when a sub advisors needs to execute away from the sponsor. Often, the goals of managing costs and attaining best execution are in conflict, which causes confusion and complications.

In 2014, the SEC performed close to thirty examinations of wrap sponsors and made two significant findings related to order handling practices.

First, they found sponsorswerent consistently disclosing the frequency and additional costs to clients when wrap orders were executed awayfrom sponsor platform. In many cases, the SEC asserted that the practice of trading away was more the rule than the exception.

Secondly, the SEC found that sub advisors practices wereinconsistent whenaggregating for execution both wrap and institutional ordersfor their clients. In particular, they found that some sub advisors were executing these block orders whereby the institutional client paid a commission while the wrap client paid nothing. Regulators support the practice of blocking up trades in order to provide best execution across their wrap and institutional clients equally, but believe that wrap accounts shouldnt get a free ride on trades where institutional clients pay all the commissions.

In response to their findings, the SEC adopted Form ADV and Adviser Act Rules amendments intended to increase clarity related to wrap account practices. In addition, the SEC fined multiple sponsors and a sub advisor for inadequate disclosures on trade away activities.

Its A Wrap

In a nutshell, the regulators found that wrap trading is now an enormous business between Wrap Sponsors and Sub Advisors. Sponsors direct their wrap business to a select list of Sub Advisors for access to their professional investment advice. In return, the Wrap Sponsors expect their wrap assets to be routed back to them for execution. But often managers struggle with balancing these arrangements and their best execution obligations.

Some advisors choose order rotation, which is rudimentary and can undermine performance for clients at the end of the wheel. Others block up or bunch orders across client types, which provides more consistent performance but allows wrap to freeload on the backs of institutional moneys commissions. Unfortunately, neither of these solutions is fully compliant. Regulators are demanding that Sub Advisors ensure that wrap trades are allocated in such a manner thatallclients are treated fairly and equitably, no client shall be advantaged or disadvantaged over another.

Although regulators have written amendments, levied enforcements and provided guidance, surprisingly many sub advisors and sponsors are still not executing their wrap orders in a complaint manner.

With MIFID IIs US rock tour now playing to sold out stadiums, some of the more nuanced conversation around wrap has been relegated to inaudible background noise. It also doesnt help that the markets low VIX/low volume jingle playing on repeat daily, keeping senior managements attention focuses on the shoring up the bottom line. So, no one should be surprised when the SEC busts out its oldie but goodie Regulation Through Enforcement and imposes additional punishments to wrap industry participants who have been tone deaf to the Jaws theme coming from Washington DC.

If you are one of those firms that isnt quite ready to name that tune, you may be at risk of being knocked flat onto your B Side.

Beyond acting as roadie for his two sons rock bands, Mark Viani is a thirty-two-year veteran of equity trading, spending the last 7 years running sell side wrap post trade execution businesses. For more information on the challenges of wrap trading, he can be reached atmarkviani1@gmail.com