Dealing with the Fall Out of MiFID II

At the recently concluded "Unbundling Uncovered" Conference in London on the 12th of November 2019, I was very fortunate to engage with many of the leading players - banks, brokers, asset managers, and regulators - in the global capital markets space discussing the impact of MiFID II regulations on the institutional investor market place. ANALEC as a financial technology company has been closely associated with the MiFID II revolution and its impact on the investment research and client-servicing industry while helping our clients (i.e., banks and broker-dealers) to navigate the evolving world of "commission unbundling" in ways that create a sustainable commercial future for their businesses.

Apart from being a Panel Member discussing evolving best practices in Research Procurement, I was also included in a one-on-one Q&A session, the full version of that conversation is laid out below:

What has changed most in the Investment Research market in the last 12 months?

MiFID II has clearly started to make its presence felt in the Investment Research marketplace. With more and more Investors, in the MiFID II world, absorbing research costs in their P&L, there has been a significant squeeze in research pay-outs to brokers; especially in the UK.

Consequently, the UK and Europe have begun to see substantial cuts in Research coverage (by banks and brokers) in many areas, with small and mid-cap stocks facing the brunt of the cutbacks. This is clearly an area of grave concern to all and raises questions around efforts to create a level playing field for both large and small asset managers in the Institutional Investor category. We have noticed that “price discovery” for various services continues to play out in the marketplace. There is some concern that we are still waiting for “price discovery” to play out in many areas of the service spectrum or prices to re-calibrate to the realities of the MiFID II world, despite almost 2 years into the MiFID II regime.

 There also remains some uncertainty at Asset Managers as to how to justify differentiated “pricing” when it comes to paying one broker-dealer over another; especially in the context of (performance) impact of the service. To assess “service impact” one must look at the service level efficacy retroactively and therefore there must be some ex-post pay-out consideration for service (consumed by the Asset Manager from the broker-dealer).

Presently, most commercial agreements between brokers/banks and asset managers have been tended to be broad agreements that cover the whole spectrum of services (without any real differentiation or selective engagement), purely to fulfill the commercial entitlements and “research inducement” compliance considerations under MiFID II.

For buy-side firms, how possible is it to run a global research procurement process given the lack of regulatory alignment?

Buy-side firms with operations on both sides of the Atlantic are obviously grappling with compliance and regulatory challenges that are vastly different in some respects, but in some measure would like to move internal processes to reflect the best-practices associated with a transparent, unbundled commission world. Europe, on the other hand, requires the additional obligation of regulatory reporting around the provisions of MiFID II regulation.

 I do believe “pricing” for services will see some level of convergence over time between Europe and the United States. However, it is worth noting that the SEC in the US will continue to keep a close eye on MiFID II impact on long-term coverage for companies in the research world; as a sharp secular decline in research coverage (as we have seen so far in some markets in Europe) will lead to concerns around the IPO marketplace and long-run liquidity concerns for small- and mid-cap companies.

The recent action by the SEC in the US to extend their NO ACTION relief to banks and broker-dealers in the US servicing Asset Managers in Europe, from 3rd July 2020 to 3rd July 2023, is a clear vindication of our long-stated position that the SEC will not look to embrace MiFID II type regulation in the US anytime soon.

How close are we to the longer-term structure of this market, and what change is still to come?

To be honest, I do not believe we are close to a long-run market structure yet; but transparency around commission “un-bundling” is here to stay. If the untended consequences of MiFID II lead to an uncompetitive Asset Management industry in Europe, with fund performance continuing to lag (or widening performance gap) US peers, there will be a strong push to re-look at some of the MiFID II provision, in my opinion.

Presently based on the empirical data collected thus far on the impact of MiFID II regulation, I believe there is a broad consensus amongst industry participants that MiFID II has largely benefited larger players, on both the buy-side and the sell-side (including squeezed out Independent Research Providers). This could be characterized as one of the unintended consequences of the MiFID II regulations and runs contrary to its stated goals of creating a more transparent and competitive market structure on both the buy-side and the sell-side of the industry.

There are allegations of "predatory" pricing by the larger players in the marketplace which has led to a more concentrated market structure with the smaller players being commercially squeezed out of the marketplace. The regulators have not explicitly acknowledged the existence of "predatory" pricing by larger players, however, there is for the first time some tacit acknowledgment of the possibility of "predatory" pricing by some.

How can research consumers and providers mitigate the main risks from the research market transformation seen since MiFID II?

The research consumers (i.e., asset managers) will increasingly find themselves at a crossroad wherein MiFID II would have wiped out coverage in many areas of the market, especially mid- and small-cap coverage and their scale of operations does not allow them to replace externally sourced research (from brokers) with their internal teams to run proprietary research. But getting to know corporates and remaining engaged in the new issuance marketplace will remain important to investors.

 For service providers (i.e., brokers and banks) a sharp decline in the wallet size and pay-outs from Asset Managers compels them to take a hard look at their research spectrum and the resulting cutbacks (in coverage) are a way to remain in business. 

 Given the above, I believe Corporate Access will grow in its importance as a service as a decline in research coverage (at banks and at brokers) will push asset managers to seek more Corporate Access to drive their internal investment decision-making. Putting aside the commercial considerations around Corporate Access (i.e., Who pays for it and how much?), I believe this is one area that is likely to grow in demand at the investor end.

Where does innovation in this market provide actionable benefits now, and where do you see the most important innovation occurring in the future?

I believe customer engagement models will go through a radical shift over the next few years. Data and analytics around the data (especially around client servicing and those that aid client servicing) will gain more significance in engaging clients. Artificial Intelligence-driven cognitive insights will drive greater customer/investor impact over the long run. This will require a gradual shift away from pure "financial statement analysis". The research product (and resulting service) will also see some changes if its entire purpose is to support alpha generation as the ultimate goal. In times of macro-level “risk-on” or “risk-off” moves, bottom-up fundamental considerations may take a back seat and asset allocation takes center-stage in the investment decision-making process. At such times, it’s important for research service providers to adapt to the changing demands in the marketplace.

Greater technology integration between the research content creation, distribution, and digital delivery along with insightful customer engagement will drive the industry to not only a more cost-competitive business model and but also raise service level efficacy at the Asset Manager end.