PRIIPs transaction costs – a bad solution that just gets worse

As PRIIP manufacturers will remember, the first draft regulatory technical standards (RTS) in 2015 introduced the concept of the “slippage methodology” to calculate implicit transaction costs.

To calculate transaction costs using slippage, PRIIP manufacturers record the “arrival” price for every trade, i.e the mid-price when the trade is placed in the market. Slippage is then calculated as the difference between the arrival price and the actual price at which the trade is executed.

The slippage cost, which could be positive or negative, depending on how the price has moved, is added to, or subtracted from, the explicit transaction costs, such as commission, taxes, etc.

Apart from the regulators who imposed this methodology, we all know that investors don’t pay for slippage and it could best be described as an opportunity cost or benefit. So £1 still buys £1 of an asset, less half the spread and any explicit costs. The cost or benefit of any slippage would be reflected in future performance.

When the first PRIIPs KIDs were published, there was an outcry over the fact that negative implicit costs could exceed the explicit costs and lead to negative overall transaction costs, implying that a fund made money from the trades it undertook, which is not possible.

In the absence of the mid-price at the time a deal is placed in the market, alternative arrival prices could be used in the following order: the most recently available price, a justifiable independent price, that day’s opening price or, as a last resort, the previous day’s closing price, which is widely published and available.

Because the RTS required that transaction costs be averaged over three years, funds with a shorter history could use the “new PRIIP” methodology for implicit transaction costs, using half of the bid-offer spread for the asset classes in the fund, combined with the portfolio turnover rate. Because no fund had been required to collect arrival prices before the PRIIPs regulation came into force, every PRIIP could use the new PRIIP methodology until the end of 2020, possibly concatenating it with the slippage methodology every six months.

PRIIPs V2

Wedded as they were to the concept of slippage, the European Supervisory Authorities (ESAs) realised that they needed to remove any possibility of negative transaction costs, particularly ahead of the inclusion of UCITS within scope of the PRIIPs regulation.

By the time the revised RTS was published, the Brexit transition period was complete, so the FCA went its own way with revisions to PRIIPs KIDs in the UK. The problem in the UK was partly solved by extending the exemption for UCITS KIIDs, which do not include transaction costs.

Both the EU and UK regulators looked for ways to remove the possibility of negative transaction costs by compromising on their calculations.

EU and UK solutions to negative transaction costs

While the EU now requires the explicit costs to be the minimum transaction costs disclosed, the FCA’s solution has been to allow negative implicit costs, but to restrict any anti-dilution benefit from taking total transaction costs below the explicit costs.

On the application of the slippage methodology, two points have come out:

• In its consultation on revisions to PRIIPs, the FCA accepted that, “when slippage is calculated over many transactions, this random element should average out to approximately zero”, which begs the question why it should not simply be ignored.

• Both the UK and EU revised rules say that the half-spread method may be used if the number or cost of transactions have been very low over the last three years.

So you can ignore slippage if portfolio turnover is low, and the effect of slippage should be close to zero if turnover is high. It sounds like they are struggling to justify their adherence to the slippage methodology.

UCITS need to adopt slippage a year early – act now

In the UK, because the UCITS exemption has been extended to the end of 2026, they will then be permitted to use the new PRIIP methodology, if PRIIPs KIDs still exist in the UK, until the end of 2029.

In the draft revised EU RTS, UCITS could use the new PRIIP methodology from the end of 2021 until the end of 2024, by which time they would have three years of arrival prices and would start to use the slippage methodology.

However, as with all things to do with PRIIPs, the end of the UCITS exemption was delayed to the end of 2022. But, along the line, nobody remembered to also extend the new PRIIP methodology for UCITS by a year. So, even if they only have two years of arrival prices, UCITS will need to use the slippage methodology from the end of 2024, and the challenge of this should not be underestimated.

When we questioned the ESAs on this earlier this year, they confirmed that the RTS makes clear that the deadline is the end of 2024. They also said that “the ESAs proposed for a three-year period to apply in their draft RTS,” but because it was not extended by a year, “the ESAs are looking further into this issue in liaison with the European Commission.”

With the Commission having greater priorities ahead of the Parliamentary elections in June, and no doubt having more important things to deal with once a new Commission is appointed, it is unlikely that any progress will be made on pushing this date back in time to stop work on slippage methodology solutions for UCITS at the end of this year. After that, there will be no need to change it anyway.

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