Recent articles dismissing potential EU reforms to MiFID II’s unbundling provisions are missing broader ramifications. EU regulators have shown themselves to be increasingly skeptical about the consequences of research unbundling, signaling that the hard-line approach engendered by UK regulators will spread no further. Asset managers who precipitously decided to pay for research from their P&L during the run-up to MiFID II will remain isolated, disadvantaged relative to most US competitors, and increasingly to Continental counterparts. An upcoming conference, Substantive Research’s online version of its well-regarded Unbundling Uncovered, will likely probe these issues more thoroughly than we can here.
The European backlash
Led by French regulators and supported by German regulators, it now appears that changes to MiFID II’s unbundling rules are inevitable, facilitated by Brexit and spurred by COVID-19. The European Securities and Markets Authority (ESMA), the EU’s financial markets regulator, takes it as given that MiFID II has impaired research on small cap issuers in its recent consultation requesting input on potential remedies (unlike UK regulators who insist that unbundling has had no effect on SME research).
On the table are a few potential changes, the most likely being some form of exemption for small cap research and support for issuer-sponsored research. In their responses to ESMA’s consultation, French asset managers called for measures making it easier to trial new research and for exemptions for IPO research similar to those being considered for issuer-paid research. The trade association for German asset managers, BVI, requested that bond research be exempted, arguing that under MiFID II European asset managers must pay for sell-side bond research twice – directly and through bond spreads.
Does unbundling reform matter?
Recent articles, one in Pension & Investments and one in IFLR, quoted UK asset managers and pundits questioning how material the EU unbundling reforms will be. ‘Rebundling’ was deemed infeasible and, because SME research represents a small portion of overall research, changes to its procurement were viewed as unlikely to make much of an impact on overall practices.
However, we suspect that UK commentators are missing a more subtle dynamic suggested by the submissions to ESMA. Take for example the submission by France’s Association Francaise de la Gestion Financiere, which represents money managers running more than €4 trillion in assets. It cited an unlevel playing field with US players, both asset managers and brokers: “US actors, exempted from unbundling at home and benefiting from a large domestic market that insure them revenues, take the MIFID 2 new research regime as an opportunity to penetrate more aggressively the European market.”
According AFG, US asset managers benefit from being able to bundle research costs: “Indeed, when European asset managers make offers to both European and non-European clients, they have to price them the cost of research. The consequence is that the costs of European asset managers appear higher to clients compared to the costs of an American asset manager.” Moreover, the cost differences are highlighted because European asset managers must obtain client approval for research budgets whereas US asset managers do not: “European asset managers must also ask their European and non-European clients for an explicit agreement on the research budget.”
What is interesting here is that AFG describes MiFID II’s research payment accounts, a process that most UK managers and some large EU asset managers chose to short-circuit by deciding to pay for research from their P&L. However, AFG argued that “medium-and small sized asset managers do not have the money to cover for the costs of research and are therefore the first to be penalized.” 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.
Research Spending by Size of Asset Manager
Source: Integrity Research
Releveling the playing field
At its core, what we now have is a fundamental policy divide between the EU and UK regulators. UK regulators laud reductions in research spending whereas EU regulators decry the falling research spending on SME research.
The Association Française des Marchés Financiers (AMAFI), which represents French brokers, argued in its response that MiFID II’s unbundling provisions, “which had neither been the subject of political discussions by the co-legislators nor been the subject of serious impact studies”, have had a detrimental effect on research spending. Reform is needed to stimulate market recovery from the coronavirus crisis: “There is a large consensus among issuers, asset management companies and research providers in at least three major markets (Italy, Germany and France) that, given the new rules, the total amount paid for research has dramatically diminished and will likely continue to fall in the coming years. In light of the current covid-19 crisis, it appears crucial to review the existing rules to enable markets to contribute to the economic recovery of the Union.”
Ultimately, ‘rebundling’ small cap research is tied to a desire to stimulate research spending. If ESMA heeds calls for ‘proportionality’ in unbundling rules, European asset managers will have explicit regulatory approval for charging clients for SME research. Like US asset managers, EU asset managers can point to the exigencies of the regulatory regime as an excuse to charge for research, a technique that has worked for most US asset managers so far.
Regulatory arbitrage
This brings us to the delicate subject of regulatory arbitrage. At the very least, the EU’s regulatory mood signals that unbundling will expand no further in Europe. UK regulators ‘gold plated’ the unbundling regulations, most notably including investment funds. However, in Europe, MiFID II only applies to discretionary separate accounts. European registered UCITs, SICAVs, hedge funds, and other investment funds are exempt from unbundling, and are likely to remain so.
This means that EU asset managers who offer investment funds have been free to pass research costs onto those funds and will almost certainly be able to continue to do so. Europeans complain that US asset managers are using their ability to pass along research costs domestically as a competitive advantage. US asset managers have the ability to make one-off adjustments reducing trading costs for separate account clients who wish to be exempted from soft dollars, while continuing to subsidize the bulk of their research spending with the rest of their clients. European asset managers have similar opportunities, and these may expand if EU regulators roll back unbundling further.
Our Take
Some hold the view that the mooted EU reforms to unbundling are minimal and will have little effect. However, at the very least the EU’s actions mean that there will be no further expansion of unbundling in Europe. European investment funds are likely to continue to pass on research costs to clients. If the EU sanctions ‘rebundling’ for SME research, European asset managers will have additional regulatory air cover for charging clients, lending support to those asset managers choosing not to absorb research costs.
More broadly, EU regulators are becoming more aligned with US regulators who question the desirability of reducing research spending. EU actions reinforce US regulatory intransigence on unbundling and give US asset managers further reasons not to absorb research costs. Consequently, we may have seen the high tide of the hard-line UK version of unbundling as fewer asset managers choose to pay for research from their P&Ls.
Further debate about this topic will take place Wednesday June 24th as Substantive Research holds its first virtual research unbundling conference, Unbundling Uncovered Online. Substantive Research expects to be at capacity of 700 registered attendees by the 24th, featuring speakers from Invesco, Capital Group, Man GLG, Citi, Jefferies, T. Rowe Price, UBS AM, FMR and Cohen & Steers.