Rarely is new regulation quite as misunderstood as the European Union’s Markets in Financial Instruments Directive II (MiFID II). Viewing it as a regional issue aimed at carving out research costs from dealing commissions, many have missed MiFID II’s potential for global impact as well as its consequences for execution and financial sector employment.
Global asset managers with any footprint in Europe have been forced to adjust their practices to accommodate the new legislation. And the dramatic fall in research costs that has already taken place will make North American and Asian regulators consider following the EU’s lead. The effects will spill over into the behavior of most listed corporate issuers, forcing them to fight harder and pay more for investor attention.
Third-party research from investment banks and brokers, previously bundled into dealing commissions, is seen by the EU as client money. Now, both the buy-side and sell-side have been forced to disentangle third-party research from trading so that hard dollars are paid for any research of value. This runs counter to US regulation, but the US Securities and Exchange Commision (SEC) has granted a temporary 30-month relief to US banks. Currently, those selling research for hard dollars need not register as investment advisers.
Alongside these developments, tough EU controls on the dissemination of research should prevent any leakage from sell-side trading revenues into subsidizing research services. This includes corporate access — the process of arranging company meetings and visits on a direct, one-to-one basis. The get-out is that corporate issuers can pay for this if they want access to investors. There should not be any problems with regular results reporting to stockholders or even marketing to investors for IPOs.
As 2017 progressed, most investment firms realized that they would need to bear the hard cost of research by themselves. If not taken on to a manager’s P&L, reporting to clients would prove complicated and expensive. Also, it would be difficult to treat clients fairly, since the impact of MiFID varied so much across different client types. Almost all realized that P&L was the only way forward, and immediately took a tougher line on research pricing.
Managers were suddenly motivated to make MiFID work as they took ownership of the research budget.
New energy has been focused on value for money. Much macro or maintenance research has been assessed as harder to value — at least, in a way that would be meaningful to clients. Many active investment firms are refocusing on alpha and want research that facilitates this. The result has been that research budgets have typically halved — assuming that previously they represented 10 basis points (bps) or so of a 20 bps commission on stocks. The numbers of major bulge bracket investment banks used to provide research has been cut by even the largest managers. Those banks have also sharply cut their pricing and looked closely at the difference between written research value and the cost of analyst and sales contact — the touch. Where investment firms consume research electronically but seek low touch, the marginal cost of providing that research may be negligible. But interaction with expensive analysts is a scarce resource, and must be charged out.
What investment banks must now focus on is profitable execution and cost of capital to achieve that. The EU has created a new type of trading counterparty — the systematic internaliser — a move that is meant to draw more trading from dark pools into “lit” venues. Many have questioned whether this will work, or if investing institutions and brokers can effectively game the new rules to optimize their own execution and limit market transparency as far as possible.
Electronic trading is accelerating, with investment firms forced to upgrade dealing systems to improve pre- and post-trade monitoring. This should allow better optimization of services and increased efficiency. But recording and reporting obligations are extensive. In theory, the mountain of data will assist regulatory enforcement — but only if it can be analyzed effectively. It is one thing for the content to be backed up securely, quite another for it to be searchable and usable.
In time, dynamic pricing of written research may emerge. How much use can be made of good sell-side insights depends on buy-side implementation: What can actually be captured by an insight before market impact? Hedge funds, in particular, can afford to pay for research that can be implemented and delivers genuine alpha. Already a few conventional active managers have contemplated returning to performance fees for funds. Active managers are using the change in ownership of research as an opportunity to review their response to fee pressure and competition from passives. For example, more purchased research may focus on sustainability metrics or environmental, social, and governance (ESG) factors.
MiFID has energized asset managers, sell-side firms, and regulators across the globe. Although the research costs involved may represent no more than 5 bps annually for a typical account, the new regulation has revolutionized thinking.
Investment firms that seize this opportunity can create a much stronger value proposition for clients.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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