Over the past few months, analysts, journalists and regulators have been opining about the impact that the proposed MiFID II language banning the use of commissions to pay for research will have on the industry. Unfortunately, most have discussed this impact from their own vested interest. The following article attempts to objectively highlight who the likely winners and losers will be if the EC adopts the most recent MiFID II draft.
Winners of the Proposed Rules
The following are the potential segments of the marketplace that could benefit from the proposed MiFID II regulations regarding research payments.
- Asset Owners: Both the FCA and ESMA have argued that asset owners (pension funds, insurance companies and ultimately retail investors) have historically been charged too much in equity commissions for the external research used by their investment managers as these commissions weren’t managed efficiently because they weren’t spending their own money. It is suggested that forcing investment managers to either pay for research out of their own pockets, or through the use of Research Payment Accounts (RPAs) will drive down this inefficient use of client commissions.
While we agree that requiring asset managers to pay for research out their own pockets is likely to reduce their spending on it, there are other possible outcomes of the MiFID II language that would not benefit asset owners. Some investment managers might use RPAs to maintain their current spending levels on external research, while others might increase management fees to pay for the increased administrative burden that RPAs would create. However, it must be noted that while spending on external research might not fall in the short run, decoupling research payments from commission volume will keep a lid on these payments as volumes rise.
- Large Asset Managers: All investment managers will be faced with increased costs as a result of the proposed MiFID II language on research payments. Either managers will choose to pay for their research out of pocket, or they will face increased administrative costs to establish, implement and manage the RPAs on an ongoing basis. However, some of the largest asset managers will choose to pay for research out of their own pockets in order to pick up market share at the expense of their smaller competitors due to the lower costs they can charge. We could also see consolidation in the asset management business as larger managers acquire some of the smaller players due to the increased costs associated with implementing the new MiFID II research rules.
- Software Providers: One group that could potentially benefit from the new MiFID II regulations are software providers. Buy-side investors who don’t want to pay for research out of their own pockets will clearly want external help in administering and managing RPAs. However, most investment banks we have spoken with are not terribly excited about providing these services since they won’t be able to charge a bundled fee for them. Consequently, we expect that a number of third-party software providers will see a commercial opportunity in providing RPA management software and services to investment managers.
Losers from the New Regulations
While there are a few winners with these new regulations, a number of participants in the financial markets could be net losers from them, including:
- Small and Mid-Sized Asset Managers: As we mentioned above, all asset managers will face increased financial and administrative costs as a result of the proposed MiFID II rules on research payments. However, due to being smaller, these costs are likely to impact small and mid-sized investment managers more severely prompting some to have to raise management fees sharply, while others will even be forced to shutter their operations altogether. This factor will also make it more costly for new managers to start-up.
- Investment Banks: Most expect that Europe’s implementation of the new regulations regarding research payments will generally have a negative impact on what the buy-side pays investment banks for their research services. According to a survey we recently completed, 54% of respondents expect research payments will decline if regulators ban the use of client commissions to pay for research (over 30% of respondents expect payments to fall more than 20%). Based on this same survey, buy-side participants expect research payments to mid-sized and regional investment banks are the MOST LIKELY to be cut, followed by payments to large investment banks. We suspect that boutique investment banks that are sector specialists are least likely to lose significant research revenue due to their deep domain expertise.
- Independent Research Firms: If asset managers spend less overall on third-party research, then independent research firms are likely to suffer like everyone else – particularly over the short run as investment managers get used to developing and administering research budgets and RPAs. However, over time independent research firms should fare better than many investment banks since they are more used to pricing their services on an unbundled basis. According to a survey we recently completed, buy-side participants expect research payments to independent research firms are LEAST LIKELY to be cut.
- Small and Mid-Cap Companies: If investment banks and independent research firms experience shrinking revenue for their research, they are likely to respond by cutting back staff and reducing research coverage. Given the ability for most investment banks to subsidize their research business with investment banking, we expect that the companies whose coverage will be most impacted by this trend will be small-cap and mid-cap companies. Ultimately, the loss or reduction in research coverage will lead to a higher cost of capital for these firms.
- Retail Investors: While retail investors might gain from reduced spending of their assets on third-party research (discussed above), two other factors could negate most of this benefit. Numerous academic studies have shown that smaller asset managers typically generate better investment returns than larger managers. Unfortunately, the new MiFID II research payment rules are likely to prompt consolidation among smaller managers – ultimately leading to poorer investment returns. In addition, reduced competition in the asset management industry might also lead to increased management fees for retail investors.
As we have said numerous times in the past, the team at Integrity Research would never advocate the use of bundled commissions as a payment mechanism for investment research if we were asked to design a model for a brand new capital market. However, that is not what the European regulators are looking to do. Instead, they are trying to address the conflict of interests that they perceive exists in the current research relationship between the sell-side and buy-side.
Integrity’s concern with the proposed approach outlined in MiFID II is that the unintended consequences mentioned above probably have a much larger economic impact on the marketplace than the benefits the regulators are trying to obtain. We suspect that ESMA and the FCA, who crafted the current MiFID II language, are not terribly concerned about the overall economic impact of their actions. Instead, they are concerned solely with eliminating the “conflict of interest” associated with allowing asset managers to use client commissions to pay for research. Unfortunately, many market participants will be stuck paying the tab to achieve this result.
If you, our readers, can think of additional winners and losers from the new rules the EC is considering regarding research payments, please add then in the Comment section below.