Over the past few months, numerous journalists, consultants, and industry executives have opined about how MiFID II’s proposed unbundling of research payments from trading commissions could harm the research and asset management industries. However, few have considered how unbundling might impact the other side of the equation – the trading business. Today’s article starts to discuss some of these issues.
MiFID II Primer
Based on the most recent MiFID II language we have seen (click here for more) asset managers will be required to establish an annual research budget, forcing them to determine BEFORE HAND what the research they use is worth to them. Most industry watchers agree that the primary uncertainty around the EU’s unbundling language is how that research will be paid for. Most agree there are two possible options.
The first outcome (and the one that is reflected in the most recent MiFID II language) is full unbundling. This is where asset managers will be forced to pay for research either out of their own pockets, or they can pay for research using a newly devised instrument called a Research Payment Account (RPA). The RPA would be funded through a new fully disclosed charge to clients, and the asset manager would use the funds in the RPA to pay both sell-side and independent research providers what they believe their research is worth (or in the case of most IRPs, the list price of their research).
The second option (and the one most industry participants hope will be adopted) is a hybrid model where trading commissions will continue to be used to pay for research. This is where asset managers will use Commissions Sharing Agreements (CSAs) to fund the RPA – up to that firm’s research budget. Thereafter, the asset manager would trade with all brokers on an execution only basis. Like in the option discussed above, the asset manager would pay for external research using the RPA.
So, how will full unbundling impact the execution business? The most obvious result of a fully unbundled model is a pretty significant drop in equity commission revenue for sell-side firms, exchanges, and other electronic trading venues. According to Greenwich Associates, the total European institutional equity commission volume totals north of $3.0 billion per annum (€2.73 bln). If asset managers were no longer able to pay for investment research using equity commissions, this total could drop by $1.6 bln (€1.47 bln). This total does not include any commission volume in North America or Asia which could be impacted as global asset managers adopt the EU regulatory model.
Second, unbundling will reduce the number of trading counterparties that buy-side firms use for a few reasons. One reason is because many institutional investors trade with some counterparties primarily as a way to pay them for the research they provide. In an unbundled world, they won’t need to trade with these firms.
Another reason we expect the number of trading counterparties to drop in an unbundled world is because of the likely administrative costs associated with trading with a firm. According to a May 2015 study by Greenwich Associates called “A Brave New World for Asset Managers-and the Brokers Who Serve Them” , they found that:
“36% [of investors] expect rule changes to prompt cuts to the number of brokers they use for trading. The reason: New regulations-even if they stop short of full unbundling-would increase the costs of supporting sell-side relationships in terms of time, administrative burden and money.”
The third major impact of unbundling on the execution business is that it is likely to make it MUCH more competitive as all trading firms will essentially become agency execution providers. This means the execution marketplace will become significantly more level as asset managers need not trade with a sell-side firm in order to pay for their research. A few of the results of this might be even lower commission rates, the increased use of sophisticated trading technology, and higher demand for good sales traders. Unfortunately, these factors may force some of the smaller agency execution providers out of the business as profit margins get squeezed.
Despite this, some agency brokers might be able to succeed in this environment as 100% of all trading volume (albeit a lower amount) will be completely discretionary. In other words, buy-side traders will be able to direct this order flow to whoever they want, without having to consider research payments.
The hybrid model is likely to have a less dramatic impact on the execution market as buy-side clients will still be able to use equity commissions to pay for research. Total commission volume will probably drop some as some asset managers decide to spend less on investment research. However, this decline may not be huge as asset managers could be nervous about promoting the perception among clients that they have been overspending their commissions in the past.
The number of trading counterparties, however, could well drop with a hybrid model as the buy-side will have very little incentive to trade with firms primarily to pay for their research. CSAs will be the obvious tool to use to pay these research brokers.
A hybrid model is also not likely to level the execution playing field like the unbundled model might. This is because buy-side clients will still have an incentive, other than execution quality, to trade with some firms – and that is to generate CSA dollars to pay for third-party research. Of course, asset managers will still be able to trade with any broker as long as they provide “best execution”, but the competitive environment under the hybrid model won’t be as fierce as it would be under the fully unbundled model.
While we believe that the EU’s unbundling proposal is likely to have a pretty significant impact on sell-side investment banks, independent research firms, and the asset management community (click here to read more), others including agency brokers, exchanges and alternative trading venues are also likely to be impacted – particularly if regulators adopt the full unbundling model we discussed above.
It is obvious to us that regardless of which approach the EU adopts, commission volume will fall, the number of trading counterparties used by each buy-side firm will drop, and competition in the execution business will rise. Consequently, we suspect many firms in the European execution business (and eventually those in the US and Asia) will face falling revenues and a significant shrinking of margins in the execution business. The real question is which brokers will be able to take advantage of the obvious turmoil in the marketplace and the availability of 100% discretionary order flow on the part of the buy-side to gain market share.