One of the largest global regulatory packages in the past ten years became effective on January 3, 2018. The European Union’s Markets in Financial Instruments Directive, more commonly known as MiFID II, originated from the European Commission and is meant to provide a European-wide legislative framework for regulating financial markets. The primary goals of MiFID II are to strengthen investor protection and improve the functioning of financial markets, making them more efficient, resilient, and transparent. The reforms have an extensive reach, applying to banks, fund managers, traders, brokers, and stock exchanges across the 28 European Union (EU) member states (as well as Iceland, Lichtenstein, and Norway). At the heart of this legislation is more detailed reporting of trades across a range of asset classes (including equities, bonds, and derivatives), the imposition of a “best execution” obligation on financial firms, and the unbundling of research and transaction costs.
Unbundling research and transaction costs is arguably one of the most debated requirements under MiFID II. In more technical terms, MiFID II prohibits “inducements” – defined as fees, commissions, or other monetary and non-monetary benefits that may induce a manager to trade with a particular counterparty. Under U.S. regulation, “inducements” are more commonly known as “soft dollars” and are permitted assuming that the adviser meets its obligation of best execution. MiFID II strictly curtails the use of “soft dollars” and requires the unbundling of research services from transaction costs. Specifically, EU investment managers can receive research only if they pay for that research (i) directly (out of their own funds) or (ii) from a research payment account (RPA) funded with client money and with client approval (or a combination of both methods). This mandate and the competitive reactions to it have begun to alter the global institutional research and corporate access landscapes, leading to fund managers in the United States demanding similar transparency over how much they are paying for research and the services they are receiving for that payment.
Institutional Research
The unbundling requirements outlined in MiFID II have led to a few notable trends in Europe’s institutional research landscape – a decline in asset manager research spending, large gaps in research spending between managers using different research funding methods, and an increased interest in smaller brokers’ offerings or specialist research requisites.
According to a November report by Greenwich Associates, European institutional investors cut budgets for external European equity research by almost a fifth (19%) in 2018. The report predicts an additional 5% to 6% cut this year, while consulting firm Oliver Wyman expects banks to lose as much as $3 billion as asset managers cut back on research spending. Further, results from a survey by U.S. consulting firm Integrity Research Associates show that research shops in Europe are making less than peers elsewhere, adding to signs that the new rules have shrunk budgets for managers. Having opted to pay for research out of their own pockets rather than clients’, asset management firms in the region are squeezing providers for every penny. The survey reinforces signs that MiFID II has put pressure on the amount European research providers charge clients. The median average payment in the European region was $25,000, about 40% lower than in North America and 29% lower than in Asia.
Further, among a variety of fee structures, the subscription model is gaining favor. Eighty-seven percent of respondents charged for subscriptions, compared with 60% in Integrity’s early 2017 survey before MiFID II took effect. While subscriptions are typically for written research, the most valuable clients paid variable fees for so-called “high touch services” such as analyst access, according to Integrity.
Recently compiled data from Frost Consulting suggests substantial differentials in research spending between managers using client money versus those funding research costs through their P&L. The divergence in research spending by client-funded asset managers ranges from double to nearly eight times that of asset managers who are absorbing research costs. Compounding the problem, the spending differentials appear to be greatest in more research-intensive segments, such as emerging markets, biotech, and technology stocks.
In addition, fund managers are choosing more boutique brokers and research providers with increasing coverage of small and mid-cap companies. According to research from Liquidnet, 55% of respondents are taking research from more than fifty brokers globally, the same as last year, but that the mix of brokers is changing. Last year, 69% of buy-side firms chose bulge bracket brokers for research, but they are now differentiating between those who provide basic waterfront coverage and those who offer direct contact with the individual analyst.
Corporate Access
In addition to the trends seen across the research landscape, the treatment of corporate access under MiFID II has been particularly problematic. Under United States regulations, corporate access is considered a legitimate research expense that meets the criteria for research services. However, the European Securities and Markets Authority (ESMA) takes the opposite view, noting that with corporate access, “there is no implicit or explicit recommendation or suggestions of an investment strategy or opinion” regarding the current or future value of securities. MiFID II requires firms to “unbundle” their execution services from other benefits or services and make those benefits or services subject to a separately identifiable charge. While there’s often a set price for reading reports, everything else – analyst calls, bespoke financial modeling, conferences – is mostly up for negotiation, leading to a wide range of costs.
According to a survey conducted by ingage at the end of 2018, 85% of corporates think more institutions and corporates will arrange meetings directly – up from 59% during the same period in 2017. Almost two thirds (61%) expect to need greater IR resources to cope with this, and the platform – which operates on a system where both corporates and investors pay – also says 71% of corporates now believe the extra costs of arranging direct meetings should be shared, up from 44% at the same time in 2017. Just 2% of survey respondents believe the landscape will not change and that things will largely continue as before.
In addition, five large investing firms, including Fidelity Investments, Capital Group, Wellington Management, T. Rowe Price, and Norges Bank Investment Management, which oversee more than $7 trillion, are banding together next year to organize a series of meetings with company executives. This is a direct threat to the millions of dollars in fees banks make each year introducing their investor clients to company management teams. This shift toward greater direct contact (bypassing brokerage firms) is certainly something others have noted and expect to grow in the future.
Wall Street’s Reaction
Although the United States has not introduced similar legislation to MiFID II, some U.S. based managers have incorporated MiFID II requirements across their client base. Additionally, more U.S. fund managers have signaled the need for standardization.
In January, Capital Group, which manages more than $1.7 trillion, said in a statement that it would reimburse clients for the third-party research it uses after “having carefully assessed the global regulatory environment and market conditions.” T. Rowe Price, which oversees about $1 trillion, has told investors that it also intends to pay for research out of its own pocket and is “looking at various options to support a move to this model as quickly as possible,” Brian Lewbart, a company spokesman, said in an emailed statement to Bloomberg. In addition, Sands Capital Management, with over $35 billion in assets, has been footing the bill for outside analysis for over a year.
In addition, the Securities Industry and Financial Markets Association’s (SIFMA) asset management unit signaled in January that it wants the SEC to let brokers accept payments from U.S. clients just for research. “Investors would be best served if asset managers were able to choose a payment arrangement for investment research that makes sense based on the individual circumstances,” SIFMA wrote to SEC Chairman Jay Clayton.
If MiFID II changes are adopted in the U.S., securities firms could face tough decisions about whether to reduce their research analysts and market strategists. In Europe, the impact has been clear, with brokers’ earnings from equity research falling an estimated 20%, or $300 million, according to Greenwich Associates. Although the SEC, which has historically considered SIFMA’s positions when crafting policy, has seemed hesitant to make the kind of changes that the lobbying group is seeking, many predict it is only a matter of time before the U.S. goes the way of Europe.
If you are interested in learning more about how MiFID II may impact your company, contact our team today.
Audrey Gibson, Analyst
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