Monthly Archives

October 2016

MiFID II: The True Cost of Research Unbundling

By | General | No Comments

The implementation of the revised Markets in Financial Instruments Directive (MiFID II) in January 2018 means that firms operating within the European Union will be forced to spend much of next year preparing a strategy for the new regulatory landscape.

MiFID II compliance issues have been widely discussed by the financial press in recent months, but reliable estimates on the expected cost of MiFID II compliance have not been available until now.

The True Cost of MiFID II

MiFID II is expected to cost firms $2.1bn in 2017, according to new research published by IHS Markit and Expand, a consultancy owned by the Boston Consulting Group. The estimate covered the top 40 investment banks and top 400 asset managers.

In the United Kingdom, where the Financial Conduct Authority (FCA) has taken a tough stance on MiFID II and its implementation, UK-based firms are likely to shoulder a large portion of the financial burden.

“There are a number of ways of interpreting the rules and they [FCA] have, for example in research, taken the more onerous one,” said Tim Cant, a lawyer to Ashurst LLP in London, in a recent article for Bloomberg. “In ordinary man’s street-speak, that is gold-plating.”

Investment Banks

Of all the firms surveyed, investment banks were found to be the least prepared for the likely event of a transformation within the financial services industry, according to the IHS Markit study.

The study found that most investment banks are planning to implement the vast majority of their MiFID II preparations in 2017. The decision to delay making preparations until months before MIFID II comes into effect could incur heavy costs for Europe’s leading investment banks. It is expected that other smaller firms in the space will gain market share as a result.

According to recent research published by EY, investment banks will be the hardest hit by the implementation of MiFID II.

Investment banks received a “high impact” score from EY in several key business and operational functions, including order handling, pre-trade transparency, post-trade disclosure, and derivative trading obligation, among others.

Critically, for the “Provision of investment services and protection of client interests” category, investment banks received “high impact” scores of 50% for all functions within that category. Namely, client assets/money, suitability, and appropriateness.

EY are not alone in their assessment. Recent PWC reports have also stated that MiFID II compliance costs will likely be highest amongst investment banks.

“MiFID II is going to require banks to rethink their strategy first of all; so they are going to have to redefine what sort of products they offer in the market, what sort of trading platforms they will operate in the future… And they will have to rethink the way that business lines interact with clients,” stated PwC in a recent report written on the subject.

The Competitive Advantage of Independents

Those least likely to be affected negatively by the implementation of MiFID II are independent research providers.

Independents dedicated to increasing transparency and efficiency in the investment research space have already begun to fragment the Asian and European marketplaces.  

“We believe the quality of research produced will increase, not decrease as the research landscape shifts towards independent research providers.  Increased competition in the research space will result in buyers taking a hard look at the true value add of their research spend.  Ultimately, we think that this will result in the best outcome for investors,” says Jon Foster, Chairman of Smartkarma.

For more on MIFIDII and our coverage of the rise of independent research providers in Europe, read our blog post here.

The Changing Investment Research Landscape – It’s Not Just MiFID

By | General | No Comments

While unbundling of research and execution has gotten a lot of attention in the wake of MiFID II, the regulation isn’t the only driver shaking up the investment research sector. But research will be consumed in a completely different manner, and competition among providers will increase as asset managers become more selective about what they buy.

There is a lot of talk around the unbundling of research and execution in the wake of MiFID II, but it is far from being a new topic on the regulatory agenda. Nor is it the sole driver shaking up the fairly static and predictable investment research sector.

In MiFID terms, the UK Myners report in 2001 started the ball rolling and there have been many false starts since. The European regulation, which is set for January 2018, is a firmly ensconced topic, forcing brokers and asset managers to review their payments structures and strategies.

There are other reasons behind the restructuring of the provision of research. Banks, which are under regulatory pressure, are closing their research departments, as they search for more profitable cost centers, while analysts are looking for different and flexible opportunities. Moreover, asset managers are becoming more demanding as the prolonged interest rate environment is pushing them to look for innovative ideas to generate alpha.

The MiFID II Dilemma

Shifting from a predominantly commission sharing agreement (CSA) managed research and execution program to full unbundling and integration of the proposed Research Payment Account (RPA) will not be an easy task. In fact, a recent study by TABB Group – “Unbundling: Opening Pandora’s Box” – showed that only 10% of European buy-side participants see themselves as fully unbundled compared to around 23% in the UK.
One of the main reasons is that few participants expected that the CSAs, which are the preferred payment option, would no longer be the main currency for payment. These agreements allow the buy-side to accrue their commissions with brokers, and separate the execution from the research component.

Under the new rules, CSAs will still have a purpose, but they will need to be supported with an RPA, which separates accounts funded by client money allocated specifically for the purpose of research payments. The RPAs would require asset managers to set a monetary budget for research that would not be tied to transaction volume. Fund managers and hedge funds that can use client money to pay for research would go down this route, while firms that cannot use client money must pay for research directly or fund the RPA themselves. However, there is industry confusion over whether CSAs can co-exist with RPAs.

For example, in its consultation paper, the French regulator advocated the CSA model, provided there are additional checks and controls in place for monitoring and measuring. By contrast, the UK Financial Conduct Authority prefers managers to have a single RPA which prevents multiple brokers from holding amounts on their balance sheet. It stated that operationally, this will require changes to current CSA accounts.

The challenge becomes even more complicated because MiFID II not only pertains to equities but across the spectrum. This means that brokers will have to provide accurate research pricing by specific asset class.

Not surprisingly, as the TABB Group report notes, these impending changes have made the sell-side rethink its research value proposition, as the buy-side will have greater accountability for which firm it chooses for such services. “If the buy-side decreases its external research spend, internal resourcing may increase but ultimately leads to a decline in sell-side investment in research provision, which in turn leads to a further fall in revenue opportunity for the banks,” according to the study.

And, although the MiFID rules are confined to Europe, global firms may not have a choice but to implement them, according to analysis by Bloomberg. It showed that the operational burden of running two different research structures might be too costly, forcing them to look toward a MiFID II-style research approach, which in turn could encourage regulators outside of the region to adopt similar regulations.

Changes Already Afoot

These changes have been coming for a long time. Many brokers have already taken action, with some, such as Nomura, closing their research departments, while others have downsized or, in investment banking terminology, “juniorized” their research and distribution teams. There has also been a tendency to tier clients in platinum, gold and silver buckets, depending on their overall spend, which has left some disadvantaged.

Another main concern among the buy-side community has been that the depth and breadth of coverage has been compromised, with the output focused on the more profitable large cap sector to the detriment of their smaller and medium-sized brethren. The same fears apply to less fashionable stocks or sectors, which will suffer if they come back into vogue at a different point in the cycle. There may not be anyone left to cover them.

The larger fund management groups have also already been building their internal resources to rectify some of these issues. In some cases, this has led to a drain of talent from their sell-side counterparts.

Looking Ahead

Against this background, it is difficult to predict just how much the new research landscape will change in the next few years, but there is no doubt that there will continue to be different configurations on the market. Competition will increase as asset managers become more selective about what they buy.

The same trends can be seen in music, where streaming has fundamentally altered the industry’s business model. In the same vein, research will be consumed in a completely different manner. There will be a greater number of independent firms that provide tailored or niche reports, as well as research platforms that amalgamate offerings from different analysts or providers with a varying range of payment options. This could cover purchasing a subscription or buying reports with cash as well as using CSA or the new RPA, depending on the fund manager’s own requirements. Whatever the end result, these are positive steps toward an investment research industry that is less fragmented and better able to serve the market.

As featured in Tabb Forum