Ostensibly part of a COVID-19 relief package, the European Commission is proposing to unwind requirements to pay for equity research on small-cap stocks separately from trading commissions. Fixed income research would also be exempted from the rules. The proposed re-bundling mechanism is far less arduous than previous measures, making it easy for asset managers to avail themselves of the exemptions. The move, coming less than six months before the Brexit transition period ends, represents a slap in the face for UK regulators who have been the ardent proponents of research unbundling.
Re-bundling small- and mid-cap trading
Using the pandemic as a pretext, European regulators are adopting revisions to MiFID II vigorously proposed by French securities regulators with support from German regulators. The rationale for undoing research unbundling is to facilitate small-cap research, making it easier for issuers with a market capitalization of up to €1 billion (calculated over a 12-month period) to access capital. However, UK regulators insist that MiFID II has caused no reduction in coverage of small-cap stocks, a claim backed by various studies.
Under the proposed revisions (see section 4.1.8 beginning page 25), European asset managers will be allowed to purchase small-cap research with trading commissions. Surprisingly, the procedure for doing so will not involve MiFID II’s convoluted Research Payment Accounts that prompted many large UK and European asset managers to decide to pay for research from their P&L. The goal is to make re-bundling as easy as possible so that “when executing trades in small and midcap issuers, [European asset managers] would not be obliged to make expensive IT changes to their order and accounting systems.” Instead, asset managers simply need to enter into an agreement with brokers to determine what portion of a small- or mid-cap trading commission is allocated to execution and which to research.
This approach sounds remarkably similar to commission sharing agreements (CSAs), the research unbundling measure prompted by the first version of MiFID and widely adopted in the US and other domiciles not directly impacted by European regulation. In the run-up to MiFID II, French regulators argued CSAs would be a sufficient mechanism for unbundling, only to be outvoted by UK regulators who insisted on the more stringent Research Payment Accounts.
Exempting fixed income research
The new regulations will also do away with requirements that bond research — including rates, credit and loan research — be unbundled, acknowledging MiFID II’s failure to reduce trading spreads as regulators had hoped. As with small- and mid-cap trading, asset managers would need to enter into an agreement with brokers “on what part of the joint payments are attributable to the provision of investment research.” For all forms of re-bundling, “the investment firm would be required to inform its clients of the joint payment.”
Issuer- sponsored research
The European Commission also proposes to improve the environment for European issuer-paid research, which has been growing since the implementation of MiFID II. The goal would be to establish “a clear set of rules on how to address the conflicts of interest” associated with issuer-sponsored research. Components are expected to include disclosure of sponsorship and clarification of distinctions between investment research and marketing communications to avoid the perception of sponsored research as advertisements or marketing materials.
However, such reforms have a lower priority than re-bundling, since the rules for issuer-paid research are viewed as more complex and requiring “further analysis with research providers and national competent authorities.”
Why the rush to roll back research unbundling? European regulators have cited anecdotal evidence of reduced small-cap research coverage, even though most studies suggest that, if anything, it is large-cap coverage that has declined post-MiFID II. We suspect a more compelling reason is to level the playing field for medium and small European asset managers who “do not have the money to cover for the costs of research and are therefore the first to be penalized” – as one French trade group expressed it. Our analysis of disclosed research budgets indicates that small European asset managers are greatly disadvantaged in their research spending relative to their larger competitors, and that US asset managers outspend their European counterparts.
Comments supporting the new re-bundling rules also made it clear that US asset managers and US brokers, insulated from MiFID II’s unbundling rules by skeptical US regulators, have been beneficiaries from the draconian unbundling rules imposed by UK regulators. The majority of US asset managers continue to subsidize research costs as permitted by US regulations while US brokers have gained market share in Europe.
The net effect of re-bundling will be to validate the US regulatory hostility toward research unbundling and further isolate UK regulators, who ‘gold-plated’ research unbundling for the UK market. UK regulators are unlikely to soften their unbundling requirements, disadvantaging UK asset managers relative to their US and European competitors.