In the last weeks before MiFID II goes live, the investment research industry is still adjusting to comply with the new rules designed to improve transparency and protect the investor. The new legislation covers a wide range of topics impacting the European financial system as of January 2018. One of the major constraints MiFID II introduces is a “no inducement” rule. It will require brokers to separate their execution and research offers, and investment firms will not be allowed to receive any research for free any more.
Buy-side firms used to receive their investment research from their brokers bundled with trade execution or other services. This practice is now deemed an inducement by the regulator: money managers may deal transactions with brokers giving the best advice and access, rather than the lowest commission for executing trades. By unbundling the research costs, MiFID II aims to provide the end clients with more transparency on what they pay for. But this overhaul comes with a series of challenges for both sell-side and buy-side firms.
“If we knew what it was we were doing, it would not be called research, would it?”— Albert Einstein
The first one is to define what investment research is. Brokers offer a wide range of services in addition to execution in order to attract and retain their clients. They may provide information regarding prices, products, market conditions, bespoke analysis, corporate contacts… This can be shared with the client in an informal manner over the phone, in meetings, roadshows or as written analysis and reports.
The definition of research given by the regulator provides guidance but leaves some grey areas: it encompasses any type of material or service including investment recommendation, “[…] substantial opinion, […] analysis or[…] insights,[…] capable of adding value to the investment’s firm decision”. This may include any piece of work influencing investments from written commentary to roadshows and corporate access. The ESMA, in an effort to clarify the regulation, excluded services such as arranging meetings with corporate executives and generic macro-economic analysis. All other materials should be either classified as research (and be paid for) or a minor non-monetary benefit that can be distributed freely. Brokers are now adapting their offer to both regulation and their clients’ needs and develop packaged offers from the basic readership package (web access to analysis and reports) to the more expensive “all-in” package including analyst and corporate access, roundtables and conferences.
Determining the right price for research is challenging on both sides of the trade, and the historical bundling does not help. Apart from large sell-side firms who staff top analysts and cover a wide scope, most research providers are cutting prices to gain market shares. Some banks, such as ING, BBVA or Credit Suisse, are even considering making part or all their research freely accessible to anyone (1) : what is public can obviously not be considered as an inducement. On their side, investment firms have to make sure they do not receive any research free and also be wary of bargains. Prices too low may still be seen as an inducement by the regulator (2). This may put firms in a delicate situation when negotiating their research contracts.
While MiFID II is a European regulation, it also impacts foreign brokers operating in Europe. European investment firms have to comply to the rule regardless the location of its provider. For example, US brokers struggle with conflicting local and MiFID II rules. The local US regulation on investment advice prevents firms that are not registered as investment adviser to sell research for “hard” dollars (i.e. direct payments). As the payments were done through trading commissions in the past, broker-dealers did not have to register. Under MiFID II, their European clients have to make payments for research that US brokers are not allowed to accept. As a consequence, the SEC recently stepped in to grant a temporary relief of 30 months during which American banks are allowed to receive direct payments for their advice (3). The SEC will also use this period to monitor the evolution of practices following MiFID II and decide for an adequate answer.
“It’s clearly a budget. It’s got a lot of numbers in it” – George W. Bush
Beforehand, money managers picked their brokers based on mixed appreciation of their execution and advisory services, as the offers were bundled together. The unbundling rule now compel firms to sign distinct contracts and allows investment firms to select providers based on their research offer separately. Independent research providers will now be able to compete on equal footing with brokers.
As there is no sign of a decrease of execution fees offsetting the additional research costs, buy-side firms have to bear with this new charge, or revise their research consumption downwards. To fund this additional budget, several options are available. According to a survey , ICMA reveals that a large majority (67%) of investment firms will bear the cost out of their P&L. This method brings the advantages to be transparent for the client and to require minimal implementation. On the other side, it impacts the firm profitability.
Some firms choose to pass the charge to their client at the risk of losing market shares, and opt for either the transactional method or the accounting method. The first method charges a research commission alongside each transaction. The commission credits a Research Payment Aggregator (RPA), which is then used to pay the research providers. This method is very similar to a widely used approach in the industry using Commission Sharing Agreements (CSA). There are still several key differences between RPA and CSA that firms need to tackle: control over the research credits, specification of a research charge distinct to execution costs, align management of the credits and the research budget, reporting,..
The accounting method, also referred to as the “Swedish model”, involves an additional specific research fee to be agreed with each client. The charge is taken out of the client assets on a regular basis to fund the research budget (either through an RPA or not).
Bringing transparency to the client.
One of the many goals of MiFID II is to increase the transparency for the end client. In addition to this new inducement rule, the directive also seeks to improve the reporting of the management firms to their clients. With the unbundling of the research costs, firms will shortly develop governance to track their budget per investment strategy and the ability to assign and report the cost to the end client. As research becomes an apparent cost center, the management firms, under the pressure of their clients may tighten the budget, and focus on research that provides added value to investments.
At this point, the future evolution of the market is unclear. In its survey (4), ICMA reports that 58% of investment firms see an increase in the short term of their FICC research spending, over a reduced number of providers for 83% of them, but they also expect to consume less research globally. On the other side, according to a McKinsey survey (5), it could lead to a 30% drop in revenues for equity research over the next 3 years, and to large cuts in analysts staff in banks.
Providers will have to rationalize their offer, research of questionable value will disappear. Some fear this will lead to a reduced coverage of small to mid-capital companies, which would lower the liquidity on these. On the other side, some smaller boutiques may profit from this by specializing on markets where the demand is not deemed sufficient by large banks. Some research providers are anticipating a decline in their revenue and look for innovative income sources from their research, such as Sanford Bernstein, that launched an ETF based on its research (6).
A probable outcome is a future where a handful of global players lead the major research markets, and niche providers answering to specific demands. Another possibility is that execution and research market will split. Some brokers would then stop producing research altogether, as it could not be used to incentivize clients, and leave the market to pure research firms. The coming months will surely see significant moves in the research and execution industry, as MiFID II comes into application.
Thomas Dufresne is consultant at Initio