More than a year into MiFID II’s lifespan, the market hasn’t really decided whether it welcomes or hates the directive. In some ways, it’s not hard to see why.
Legislators envisioned MiFID II as a way to usher in more transparency in the investment industry, preventing practices like opaque trading and cryptic fee schemes. But as time has gone by and the impact of the legislation has properly hit the ground, it seems the unintended consequences keep battling the intended ones for supremacy.
With this in mind, what does the short-term future look like for MiFID II and any potential successors? It’s always tricky to break out the crystal ball – the markets are an unpredictable beast at the best of times, and one could say the current times are far from the best.
With that said, we can perhaps attempt to highlight some trends to keep an eye on for the rest of 2019 and going into 2020.
Regulators Will Keep Digging into MiFID II
While several member states in Europe have yet to incorporate the directive into their national legislation, some regulators are examining MiFID II’s effectiveness in its stated objectives.
Most notably, French watchdog Autorité des Marchés Financiers (AMF) has launched an investigation on the directive’s true impact on small- and mid-cap research. Depending on who you ask, research coverage of such firms is either dwindling or gaining ground. It seems the AMF wants to finally figure out what’s true.
“The coverage of listed companies by independent research is an essential component in ensuring that prices are properly established on the market and to guarantee liquidity,” the AMF’s announcement reads.
“While the large listed companies are widely covered, small caps are traditionally less followed by analysts. The implementation of MiFID II, which requires research to be billed separately, seems to have both accentuated this trend and modified the market economy of research.”
On the other side of the Atlantic, the US has launched its own probe into investment research on small issuers. The House of Representatives recently passed the Improving Investment Research for Small and Emerging Issuers Act.
Under the bill, the SEC must study the current investment research market for small-cap firms. This includes size and concentration of fund managers, impact on demand, and how the market prices research.
If it sounds very similar to what MiFID II is trying to accomplish, that’s because it is. It has been clear for a while that the US would take measures to accommodate repercussions of the European directive.
The SEC, for example, granted temporary exemptions to US brokers and investment advisors dealing with European clients, so they would not fall foul of regulations.
Continued Challenges in Research Pricing
As the unbundling of research costs from service fees proceeds, market watchers have noted that traditional sell-side provide their research at extremely low prices. This disproportionately affects independent research providers who cannot hope to be sustainable by racing larger providers to the bottom.
“Sell-side firms continue to under-price their research. The backdrop for independent research providers is tough against this practice,” says Said DeSaque, a macro analyst who publishes on Smartkarma.
With more and more independent analysts coming to the market, such practices could put a damper on the diversity and quality of available research. “Perhaps regulators will need to get involved,” DeSaque adds.
France’s AMF makes a similar point in its aforementioned announcement. “The fall in prices of invoiced research, coupled with the streamlining of investors’ budgets, has had an impact on the number of analysts and the coverage of firms,” the regulator says. It further notes that sponsored research is on the rise, which raises the spectre of conflict of interest issues.
“Lower levels of compensation will mean analysts of lower caliber and hence research of poorer quality,” warns DeSaque. “Sell-side research has been poorly priced for years and the current environment suggests this will not change anytime soon.”
Increased Demand for Transparency
Part of the European legislators’ mandate was shedding more light on trading. For example, we have mentioned before how trading ETFs would traditionally happen over the phone before MiFID II came into force.
The legislation also targeted “dark pooling”, a practice where investors trade without disclosing information about those trades. The directive imposed a cap on the practice, in order to encourage more trading within “lit markets” such as exchanges.
Observers warned of the possibility of trades shifting to Systematic Internalisers (SI), investment firms dealing on own account when executing client orders over the counter on an organised, frequent systematic, and substantial basis.
The concerns seem to have justified, with the AMF noting last year that SIs had multiplied as a result, and that MiFID II had not been successful in its mandate for transparency.
Recently, the European Securities and Markets Authority (ESMA) has been publishing more data on equities and equity-like instruments SIs trade. It also updated information to improve supervision and adherence to regulations. ESMA’s efforts will continue through 2020, with publication of non-equity instruments and derivatives, as demand for transparency gains more ground.
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