The following is a guest article by Neil Scarth, Principal of Frost Consulting (www.frostconsulting.co.uk/) which provides customizable research budgeting/valuation frameworks and research spending databases.
Leon Festinger was an American psychologist who in 1957 first coined the phrase “cognitive dissonance”. This was an explanation of why so many people staunchly defend their opinions and beliefs even in the face of overwhelming evidence to the contrary.
Viewed in the context of a Tsunami of global regulatory change related to research payments, the prevailing global self-assured consensus is that, regardless of regulatory transformation, no change in current research payment processes is possible.
Financial crises aside, normally financial regulation evolves at a glacial pace. Yet, a mere three months from now, given the raft of imminent potential regulatory changes that are evolving on an almost daily basis (particularly in the EU), the world could look like a very different place.
During normal circumstances, any one of the regulatory initiatives listed below would have been a big deal in and of itself:
To have them occurring simultaneously, and on such tight timeframes is unprecedented.
As Vladmir Lenin famously said, for many decades nothing changes, but sometimes, decades can happen in a week.
The human memory is sometimes short. It was not that long ago (2016) when the investment world was convincing itself that MiFID II would not be a big deal. So, we find ourselves in a familiar position.
Just as we were in January 2016, the market is currently in Stage One denial. But unlike in 2016, rather than having two years to adjust to the new reality, in this case we have little more than two months.
Why Now?
There are many intersecting causes, but the key elements in Europe are Brexit, ESG considerations and Fear of a Bear Market.
Brexit is a natural juncture for the UK to review EU legislation it might not like (MiFID II??). This is identical excuse for the EU who reluctantly included research inducement clauses insisted on by the UK regulator in MiFID II in the first place.
This is a game of “regulatory chicken” in the UK/EU battle for post-Brexit market share in financial services. If the UK, which moves first at the end of June, decides that the pre-Brexit MiFID II research rules are perfect (unlikely), and Europe liberalizes research rules soon afterward, that could place UK managers in an uncompetitive position.
The other key point from a UK perspective, is that this MiFID II Research Review is being run by the government (HM Treasury), not the regulator (FCA). The current UK government cares deeply about having a viable national capital market and a globally competitive asset management industry (The FCA? Not so much).
The terrible simultaneous multi-asset class returns of 2022, (the worst since 1969) also concentrated the minds of governments (and even some regulators). There was a startling recognition that the research via P&L method may not be ideal when markets decline, because the lower markets go, the less and less research managers can access when it’s a function of their profitability.
This is where ESG comes in (at least in Europe). When European asset managers decided to fund fundamental research via P&L, they had no idea that:
- They were unconsciously committing themselves to funding ESG and Stewardship from the same source (their P&L), or
- That ESG AUM and expenses would grow so rapidly. (By 2025, Frost Consulting estimates that European asset managers may spend more on ESG/Stewardship than on fundamental research).
This sets up a duration mismatch that would make Silicon Valley Bank proud. European asset owners have essentially outsourced increasingly expensive ESG and Stewardship activities to their external managers who must fund this (as well as research) from their market-dependent P&Ls.
Europe is trying to fund long-term ESG objectives such as carbon neutrality in 2050 via asset managers whose revenues re-set quarterly and ESG budgets are created annually, 30 years in advance of the target.
As long as markets in multiple asset classes go straight up until 2050, no problem. But, if there’s any market volatility between now and then, European ESG objectives will fail spectacularly unless:
- Governments fund the entire energy transition on their own, or
- European asset managers become not-for-profit social enterprises.
To be sure, some things haven’t changed. Are asset owners in a hurry to pay for manager research costs? No. Are asset managers in a hurry to ask them? No.
But unless governments/regulators in Europe find a way to entice European asset owners to use their long duration and low research costs to support the research ecosystem, (as they do in the US under 28 (e)), the European capital markets, and any hope of ESG objectives being achieved, will wither on the vine.
The common ground of ESG (in Europe) may be part of the answer, as both asset managers and asset owners share these objectives.
Where there is no possibility of change, there is no need for innovation.
But because we are Busting the Myths of MiFID II, Frost Consulting and Northern Trust are working on innovative solutions for all of these issues – including simple solutions for P&L managers caught by the Expiry of the No Action Letter.
We may go into more detail in subsequent articles. In the meantime, we’ll be looking for Dr. Festinger.