What is MiFID II
MiFID – Markets in Financial Instruments Directive – has been a main governing force of the EU’s regulation of financial markets, starting from 2007. It covers all financial instruments (i.e., shares, bonds, ETFs, funds, derivatives, etc.) which has successfully created competition between investment services and has provided investors with more choice and lower prices.
MiFID II which will be entering in January 2018 seeks to unbundle, among other things, the trading commission and investment research fees paid by asset managers to brokers and thus addressing the problem caused by market fragmentation and dark trading, especially after the financial crisis in 2008. Therefore each piece of sell-side research will carry a cost, and asset managers will have to justify the purchase of any research to asset owners or pay for it out of their own pocket.
“Member States shall ensure that the provision of research by third parties to investment firms providing portfolio management or other investment or ancillary services to clients shall not be regarded as an inducement if it is received in return for any of the following:
(a) direct payments by the investment firm out of its own resources; or
(b)payments from a separate research payment account controlled by the investment firm, provided the following conditions relating to the operation of the account are met…“
- Article 13, Delegated Directive of 7 April 2016
“Initial regulatory impetus came from the UK, and has now spread to the EU. Ultimately, the effect is likely to be global. The European Commission is one of the world’s most significant voices, regulating the globe’s largest economy. Globally active managers, who will want to meet the highest standards in the best interests of their clients, may voluntarily move to adopt a similar approach, which would likely have a knock-on effect for international suppliers of execution and research services.”
- White Paper -The Future of Equity Research
The End Of Commission Payments
As an investor, the primary factor that will impact is the changes to how he will pay for research. And executives and fund managers at asset funds are worried. The subject is huge and complex, and there is always the risk of missing something.
The UK financial regulator in 2013 went further than the European counterparts when it banned the practice of asset managers paying commissions to financial advisers in return for product recommendations. Now the EU is following the UK’s example and under Mifid II, commission payments to independent financial advisers will be banned.
The established model has been for banks and brokers to spread their research far and wide and look to get paid after the fact, in the form of commission charges on trading or through direct payments. Historically, these costs were usually passed on to the investor in the fund.
Furthermore, so far asset managers have put together trading and research costs into a single fee, often receiving research from an investment bank or broker in exchange for using them to carry out trades. Now Mifid II requires that asset managers budget separately for research and trading costs – literally this means a kind of “unbundling”. More than a fifth of fund managers planned to charge investors an extra fee to cover research costs, according to the survey by RSRCHX change, an online marketplace for institutional research.
Conflicts Are Obvious And Clear
The new system will mean fund managers specify how much they are paying for research and then either pass it on to investors or pay for it themselves.
Passive fund providers, which traditionally do not pay those commissions hope the directive will enable them to win more business. Also, smaller investment managers may be disadvantaged, given the relative impact any increased expense would have on them.
For the large-cap equities, currencies, commodities and indices, the changes should reduce research to a more manageable level. Many funds have a team of analysts to carry out analyses but many other funds do not have this fortune. Maybe we will be facing a new system where only the big fund managers will properly operate at this end of the market?
One of the key point is, if we have more transparency, prices could be driven down; this is considered as an option according to important legal firms – such as DLA Piper – but that might be at the expense of having fewer players in the market and therefore pricing might not get worse, but liquidity could be the real issue.
Therefore the negative side is quite simple: less research coverage means less daily liquidity, more volatility and more pricing anomalies, and maybe less quality companies joining the financial market – and start an IPO process.
Nevertheless, as the subject is hot and still not finalized, maybe brokers providing research and organizing roadshows will still be remunerated by investment managers although they will have to ensure the payments are not falling in the concierge service. At the same time, the fund managers will probably have to make sure if corporate access services (e.g. roadshows, conferences, and one to ones involving a corporate issuer & facilitated by a broker) are material benefits or qualify as MNMB (Minor Non Monetary Benefits).
At the end of the day, in the new era, the market will face more competition in the research world, and fund managers will be definitively more demanding about what they buy. We believe that smaller managers might struggle, while the larger institutions will be less impacted as they will leverage on their internal analyses.
Furthermore, once the changes are enacted, and the market adapts accordingly, brokers will have to start increasing the amount they charge their corporates for research. The other outcome will almost certainly be a further consolidation of brokers. In both cases, we might, unfortunately, see a thinning out of research.
Hence, clearly many items as well as many decisions are still pending. In our view, the number of research will be lowered but, and this is the good news, maybe the quality will increase: analysts are going to sell their work in a better way and thus will focus less – or not only – on financials and more on the corporate strategies and ESG factors. We will probably see more SM caps paying for research, IROs to do more homework and IR and corporate access firms to be more present in the new landscape.