The following is a reprint of an exclusive article published for ResearchWatch subscribers on December 27, 2017.
MiFID II’s research unbundling provisions, which went into effect early last month, will create intended and unintended consequences for the European research industry, along with global ramifications. In some respects, the new rules have created more transformation than regulators expected, while failing in other aspects.
Although the full costs and benefits of MiFID II will become more apparent over the next year or two, we can already discern areas where the new regulation is succeeding as well as where it falls short. Let’s first examine where the rules are working as the regulators intended.
The majority of long-only European asset managers plan to absorb research costs, an unexpected result even by regulators. In our latest Research Funding Scorecard (subscription required) we show 101 asset managers who announced they will fund research from their own resources under MiFID II compared to 5 that said they will fund research costs alongside commissions and 3 firms which will pass research costs to clients through explicit research charges (the so-called Swedish Model.)
However, global asset managers have chosen to ring-fence their cash payments to MiFID II clients, which means the bulk of their assets — representing over $21 trillion by our estimates – will continue to be funded alongside commissions outside the EU, at least for now. This has resulted in increased regionalization, an unintended adverse outcome (more on this below).
Research Budgeting and Valuations
MiFID II has prompted asset managers to improve their budgeting for research costs and to implement more robust research valuation, implementing more enhanced broker voting. We expect expanded budgeting and valuation to become global best practices, irrespective of how successfully other aspects of MiFID II are exported beyond the EU.
Rigorous Price Negotiations
Partly as a consequence of the decisions to fund research costs through their P&L, asset managers are more proactively engaging brokers and banks in fee negotiations. As we have been tracking in our research fee updates (subscription required), quoted research fees fell over the second half of the year, especially for subscriptions to written research. We are told by sources at bulge bracket banks that the majority of their clients are still in negotiations over fees.
As confirmed in a recent survey we conducted, the majority of asset managers intend to use interactions data as part of their valuation process, which is placing increasing focus on the charges for research components such as analyst calls and conference attendance.
Goodbye Research Firehose
MiFID II is ending the ‘firehose’ distribution (subscription required) of research in Europe, requiring brokers to send research only to asset managers who agree to pay for their research and requiring asset managers to block any research they don’t want to buy.
Despite this, banks and brokers are still thinking of written research as ‘marketing chum’ (subscription required), where the purpose of research reports is maintain mind share and draw clients into higher value services like corporate or analyst access, prompting them to set the price of written research low or, in the case of macro and some FICC research, at zero.
The biggest winners from unbundling will be fintech firms offering technology to make research more efficient, improve the utilization of external research, showcase independent research and/or facilitate research distribution, not to mention those firms with solutions specifically designed to comply with the new unbundling rules.
We count nine firms offering research management solutions (subscription required) designed to better organize and leverage internal and external research. There are at least thirteen firms offering to facilitate corporate access meetings (subscription required). We reviewed ten firms offering services to help administer Research Payment Accounts mandated for those firms funding research payments from client assets. There were fifteen firms vying to distribute research before Airex faltered (subscription required).
We have long argued (subscription required) that investment bank research will become more innovative in an environment where research payments are increasingly differentiated from execution. Historically investment bank innovations were impeded by the difficulty in getting paid for incremental services in a bundled world. With unbundling, those obstacles are reduced, making it easier for investment banks to get paid for incremental, differentiated research product.
Better Quality Research
Although not necessarily a given, we expect the quality of sell-side research will improve as the buy-side becomes more selective and as research producers get more granular feedback. However, the user experience may not improve, especially for portfolio managers and analysts at smaller asset managers. All European buy-side research consumers — irrespective of whether they are with large or small firms — will need to adjust to a reduced stream of information as the research firehose dissipates. If the research industry becomes increasingly subsidized by investment banking and wealth management, institutional investors may be less well served since the demands of banking and wealth management may be distinct from what best serves asset managers. If the research industry becomes more concentrated, this may detract from diversity. European macro research may become commoditized as banks give it away free under the so-called Danish Model.
The final research unbundling rules in MiFID II were the result of regulatory haggling, with UK regulators pushing for a full ban on funding research using client commissions and other regulators led by the French arguing for more moderate reforms. Although the end result allowed the use of client assets to fund research, the convoluted prerequisites forced the majority of European asset managers to opt out by choosing to fund research from their own P&L, a result that even UK regulators did not expect.
During the process, opponents of the UK’s draconian approach voiced concerns over the potential consequences of unbundling, but the regulators apparently assumed that change would be more gradual than is actually playing out. Also, European regulators gave scant consideration to the results of not harmonizing their rules with other domiciles outside Europe such as the US. Consequently, it is already clear that MiFID II’s unbundling provisions are going to have negative effects which are not what European regulators intended.
Asset Management Consolidation
It is increasingly apparent that research unbundling will be toxic for smaller European asset managers. Consultant Oliver Wyman estimated that the profitability impact of research costs on the P&L of asset managers is material, equivalent to a 4% to 7% profit reduction on an industry basis.
The profit decrease will be larger for smaller asset managers. A recent survey (subscription required) of European asset managers conducted by the CFA Institute showed that European managers with less than €20 billion ($23.5 billion) in assets (half the 365 respondents) estimated research costs ranged between 10 and 38 basis points. In contrast the larger firms responding to the survey estimated research costs between 0 and 5 basis points.
The problem is not just reduced profitability, but also reduced access to external research. Take London-based JO Hambro Capital Management as an example. With only £29.2 billion ($40 billion) in AUM (less than 1% the size of Blackrock), the firm expects (subscription required) to take a £5 million ($6.8 million) hit to its P&L, which will be an 8% reduction in its profitability based on the company’s latest regulatory filings. Just as challenging is the breadth of its investment products: although over half of its assets are focused on UK and European equities, the firm also invests in US, Asian and Emerging Markets equities. A £5 million research budget may allow it to purchase written research to cover all its invested markets, but is unlikely to pay for more value added services such as analyst access, financial models, events and other high-touch services.
Thanks to MiFID II, smaller European asset managers will suffer lower profits, reduced access to higher value research services, pay their staff less (risking staff defections) while try to remain competitive in an industry where increasingly size is key. Research unbundling will therefore exacerbate the existing consolidation trend in the asset management industry, providing one more reason why mergers provide greater operational efficiency. Large firms will get larger, while mid-sized and small asset managers get squeezed.
Exacerbating the stress on smaller European asset managers, MiFID II has also created an uneven playing field for European asset managers competing with US asset managers. Large US asset managers such as Blackrock, JP Morgan, Goldman Sachs Asset Management and at least sixteen other global managers have chosen to ring-fence their MiFID II obligations. This means that the firms are paying for research sourced from Europe from their P&L while continuing to fund all other research payments with client commissions. As of our latest Research Funding Scorecard (subscription required), the assets of global managers being kept outside MiFID II totaled $21.3 trillion, dwarfing their $4.8 trillion of assets directly subject to MiFID II.
The natural recourse for European asset managers will be to promote their cost advantage, but Oliver Wyman estimates the cost advantage to be a negligible 1 to 3 basis points. The cost advantage will be smaller, the larger the US-based competitor. Unlike the UK, where asset owners have been receiving Level II disclosures since 2006, US asset owners receive no such disclosures other than general policy statements which universally say that asset managers utilize soft dollars and cross-subsidize research payments across client accounts. European asset managers will find the knowledge level among most US asset owners to be very low for a competitive advantage that may be relatively small.
Reduced Coverage of Small-Cap and Mid-Cap Issuers
Anticipating a decline in small-cap and mid-cap research coverage in the wake of MiFID II’s unbundling provisions, European exchanges such as Deutsche Börse and Borsa Italiana are promoting issuer-paid research (subscription required) for listed companies. A white paper issued by Deutsche Börse, German Investment Funds Association (BVI), the German Share Institute (DAI), the German Investor Relations Association (DIRK) and the German Society of Investment Analysts and Asset Managers (DVFA) argues that both research coverage and corporate access for small-and mid-cap issuers will suffer under MiFID II.
Unreformed FICC Research
European regulators struggled whether to extend unbundling provisions to asset classes other than equities, with Continental regulators questioning how meaningful the reforms would be for markets where research costs are baked into bid/offer spreads. These concerns are being validated as it has become apparent that fixed income, commodities and currency spreads will be unaffected by unbundling, meaning that dealers will retain current levels of funding already embedded in spreads while ostensibly putting prices on some elements of FICC research. The result is that FICC research remains essentially bundled, with dealers benefiting from any incremental fees charged for FICC research services.
The situation is aggravated by a MiFID II loophole (subscription required) which allows banks to give FICC research for free if it is publicly disseminated. By our count (subscription required), at least eight banks are giving away ‘free’ research, utilizing the so-called Danish Model pioneered by Danske Bank.
Lack of Research Pricing Transparency
MiFID II assumes that research pricing, cost and value are interchangeable, but that is not the case (subscription required). Research pricing confusion has been exacerbated by requirements that both asset managers and research providers set values for research. Asset managers are required to conduct regular assessments of the quality of the research purchased and “its ability to contribute to better investment decisions.” At the same time, almost as an afterthought, MiFID II requires brokers to provide “a separately identifiable charge” for any services beyond execution.
This inherent contradiction within the MiFID II language explains why we are seeing only token efforts (subscription required) by banks to assign explicit pricing to research services. Essentially, MiFID II is perpetuating a negotiating process for research where the buy-side comes to the table with assigned values and research providers counter with their “price”, which is not a universal value communicated to all clients but a customized quote unique to each client. Negotiations are bi-lateral resulting in a minimum amount of price transparency.
The inherent contradiction between value and price — and its perpetuation by MiFID II — will slow the progress of greater transparency for research pricing. Research payments will continue to be set by bi-lateral negotiations which are customized to each client. However, the negotiations are getting sharper as asset managers have more skin in the game, and there is more granularity supplied by interactions data.
Because bi-lateral negotiations remain the main mechanism for setting research payments, the entry fees can be set relatively low, hence the race to the bottom on base-level subscriptions. This has the added benefit (to banks) of squeezing those firms which solely rely on explicit pricing for their research, the independent boutiques.
Fee Pressure on IRPs
European regulators made pronouncements that unbundling reforms would level the playing field for independent research firms, but boutiques are very uncomfortable with how MiFID II is playing out. A survey (subscription required) by trade organization Euro IRP found that “members are uncertain that [MiFID II’s] best intentions will deliver the best outcome.” Independents are particularly concerned about ‘predatory pricing’ as banks have been setting low subscription fees for written research. The issue is particularly acute for European macro research boutiques as banks are choosing to give away their macro research under the Danish Model.
UK regulators have expressed ambivalence to IRP concerns, saying that if the rules mean “customers are paying less for the same or better service that is a good outcome.” Regulators would have difficulty establishing that sell-side pricing is below cost given that high touch services are priced high and that most banks have other businesses such as investment banking and wealth management to support research departments.
Asset Managers Opt Out of Procurement Reforms
One of the regulatory selling points of the new research inducement rules under MiFID II was that they would improve transparency around the purchase of third party research. However, the decision by a majority of Europe asset managers to pay for research themselves means that the elaborate strictures proposed by regulators no longer apply (subscription required). The P&L approach also makes it easier for banks to charge for services that European regulators disapprove as research, such as corporate access.
MiFID II’s research unbundling rules stipulated a variety of requirements: explicit research charges negotiated with clients, budgets, research valuations, written policies, controls and disclosures. For the most part, these are moot now that most European asset managers are choosing to pay for research from their P&L. Aside from some form of budgeting and research valuation, all the rest of the MiFID II research requirements – explicit charges, policies, controls, and disclosures – will be extraneous for asset managers paying for research from their own resources.
Another consequence of unbundling research from execution is making research services subject to Value-Added Tax (VAT) (subscription required), which will further erode research provider revenues, hurting mid-tier and smaller research brokers. The UK’s fiscal watchdog estimated (subscription required) that new VAT taxes on UK research would raise around £40 million ($53 million) a year, increasing to £45 million ($60 million) after four years. Whatever the amount, it is money that will no longer go to research providers.
As European institutional investors become less able to cover research costs, European banks are being forced to subsidize research through other means. For investment banks, corporate finance is an important source of cross-subsidization, as are wealth management units. Several UK brokers have indicated that they are restructuring their corporate access services as ‘issuer-paid’ (subscription required) so that the services can be offered free of charge under MiFID II. Some research firms are creating ETFs and other investment vehicles (subscription required) based on their research.
At the very least, increased demands from other research constituencies place strains on finite research resources. At worst, they increase potential conflicts as research analysts must serve different masters, keeping bankers and issuers happy. Australian regulators recently tightened their regulations governing conflicts between research and banking, and European regulators will likely need to also increase their vigilance in the wake of MiFID II.
Outside of the UK — the epicenter of research procurement reforms — it is unclear how consistently the rules will be enforced (subscription required) as even European regulators are struggling to implement MiFID II. As the rules go into effect, eleven EU countries have yet to transpose the MiFID II rules into their local market regulations and EU officials have launched infringement proceedings against dilatory member states. Even among members which have enacted the rules, enforcement will likely differ in degree and diligence, reflecting the different perspectives on unbundling made clear during the rulemaking process. UK regulators, which were the proponents of stricter unbundling regulation, have consistently adopted more stringent requirements than their Continental counterparts.
Impact on US
In October, the U.S. Securities and Exchange Commission issued (subscription required) three no-action letters intended to facilitate the ability of US brokers and asset managers to comply with the research requirements of MiFID II in a manner that is consistent with the U.S. federal securities laws. Taken as a group, the actions make it easier for asset managers to isolate MiFID II reforms while continuing to avail themselves of US regulation permitting the use of client commissions to fund research payments. The SEC ‘kicked the can down the road’ according to a dissenting commissioner on provisions allowing US asset managers not subject to MiFID II to pay cash for research, deferring any relief for US brokers accepting cash payments from US asset managers for 30 months.
Nevertheless, asset owner pressure may force US asset managers to adopt methods of reimbursing research costs, despite the indifference of US regulators. First Eagle Investment Management, a US-based asset manager not directly subject to MiFID II, said (subscription required) it will fund all external research costs from its P&L effective January 3, 2018. MFS also announced a policy of paying for research from its P&L globally, although it did not specify when it would implement the policy in the US.
The full impact of MiFID II remains to be seen, such as how deeply European asset managers cut research spending, the extent asset managers outside Europe choose to reimburse research costs, and the full impacts on European research providers and asset managers. However, it is already clear that the new regulations are creating results that were not intended by European regulators. Some of the current issues may be corrected by EU regulators or mitigated over time, but at this point it is an open question whether the costs of research unbundling will offset the gains.