MiFID II calls for the banning of trading commissions to pay for research and research related services, to create more transparent and competitive financial markets regime. Some wonder if the unintended consequences of this move could lead to greater concentration of the market structure and reduction of choice.
MiFID II entered the lexicon of terminology in the financial markets since 2011, when the European Commission issued draft directives that applied to markets for financial instruments, looking to repeal the previous guidelines and regulations that have been in place since 2007. For those of you who are still unclear on what MiFID II stands for, it is “Markets in Financial Instruments Directive”. The “II” stands for “Part II” as the first bit of directives was initiated in 2004. MiFID II relates to changes that are being contemplated since 2011, via legislation in Europe in the markets for financial instruments. The ultimate obligation to implement the final version of the MiFID II provisions would rest with the European Securities and Markets Authority (ESMA).
While its implementation would largely be a European phenomenon, it has far reaching implications for the global financial markets management from a standpoint of its future evolution and regulatory oversight considerations. Given the global nature of the money management industry and significant exposure to European laws and regulations for various money managers, such legislation has implications beyond Europe. If recent press articles are to be believed, it seems the implementation of MiFID II may not take place till January 2018. While the Chairman of ESMA puts the implementation delays to logistical challenges to put in place for the new regime, we believe it also has to do with lack of consensus on the way forward on various fronts.
MiFID II has a whole series of obligations and compliance norms that apply to the asset managers and brokers, some being contested more than others. However, the area getting a lot of press coverage over the last year has been the commercial model surrounding the provision of investment research services from financial intermediaries (e.g., broker-dealers and full service banks) to the asset managers (i.e., fund managers, pension funds, hedge funds etc.), also referred to as institutional investors.
In this write up, I intend to keep my focus on the pricing of investment research from the sellside (i.e., brokers, investment banks and independents) to the buy-side (i.e., asset managers and hedge funds).
Prior to MiFID II, investment research from the investment banks and broker-dealers (to the buy-side) was provided as part of the "full service" commission rate charged by the brokers for the trading stocks for on behalf of their clients. This "full service" commission rate paid for the execution service of actually transacting in the exchanges, as well as the "other services" - research and investment ideas, analyst and sales support, corporate access etc.
In other words, as an institutional investor if you instructed a broker to "buy" (or sell) some shares for you in the stock exchange, you agreed to pay a commission of let’s say 0.15% (or 15 bps); out of which "pure execution" services cost you 0.02% (2 bps; or lower) and the rest of the commission is assigned to the "other services" you consumed from the broker. The bul of the "other services" charge relates to the provision of investment research and related services (i.e., analyst and corporate access etc.) from the broker to the asset manager.
Over the years, institutional investors have negotiated hard with their brokers to lower the "full service" commission rates and have gone a step further to ask them to dis-aggregate the commission charges into its various components. This dis-aggregation demand was been popularly coined as the "unbundling" of commissions. The un-bundling objective was to create more transparency and accountability around the broker-asset manager relationship; while ultimately demonstrating transparency by the assets managers to their ultimate clients (institutions that give them the money manage in the first place).
Asset Managers in turn are increasingly under pressure to improve fund performance as well as provide greater transparency around their trading activities and the use of such trading commissions to "pay for" services to feed the investment process. Active assets managers have failed to deliver alpha and this under-performance has brought about greater scrutiny of their activities by their clients.
The un-bundling phenomena put pressure on commissions being allocated towards paying for "research services". But use of trading commissions to pay for research was not questioned. Under the MiFID II deliberations so far, the use of commissions to pay for "research services" has been called into question and this has rattled the industry as a whole - both sell-side and buyside.
The present view on research payments in the MiFID II world is as follows:
The discontinuation of use of trading commissions to pay for research services (including Corporate Access) raised significant commercial viability questions on the future of sell-side research. However putting in place the mechanism as highlighted above, in many respects is the easy bit, looking at it from the perspective of a buy-side entity. The question that is more complicated to answer is - How do you put a price tag on third-party research and research related services (i.e., broker provided research services) when it involves a recurring service commitment?
As an sell-side analyst myself, working for a number of global investment banks over a career spanning 11 years; we provided a range of research related services to our clients: (a) we would publish research reports on specific companies and sectors; (b) we would make company visits and follow up proactively with our clients with published notes and phone calls (or meetings) to inform them on our findings and inferences; (c) we would facilitate access to company management teams for our clients (aka Corporate Access); and (e) we provided our clients the ability to talk to us on matters in our sector or coverage and seek our counsel. All of these “activities” put together constituted the "research service".
Pricing a piece of research published on a company, or a piece of research published on a sector,similar to the IDC or Gartner model is easy but this is not how the asset manager - broker relationship is defined presently. The broker organization provides an on-going recurring serviceand hopes to get paid a fee for such "services" in the embedded commission rate charge to the asset manager for trades executed. Under the MiFID II's RPA approach, all such services would be captured in the "price" paid for the "research service". The question that remains unanswered is if there will be any provisions for a variable component to reflect value-add (from service provider) over time? Or else do you put a price on each email or phone call that a salesperson or analyst from a brokerage firm makes to the asset manager?
Under the MiFID II environment, the menu-based pricing mechanisms that some have talked about is fraught with its own challenges, especially given the "recurring" dimension to this service proposition (from a broker to an asset manager). One will have to move to a price tag for covering a specific sector or a market and that "coverage" definition has to be clearly defined to remove ambiguity and confusion; and value-add over time needs to drive the compensation conversation for such services. Secondly, even after you have addressed the definition, some aspects of the "recurring service" may NOT be approved for payment using trading commissions (if trading commissions are not entirely banned from making research payments) and therefore have to be paid for separately. For example, Corporate Access is being clearly highlighted as something that will NOT be allowed to be paid for using trading commissions and needs to be paid for by the asset manager separately (presumably via RPAs).
Subsequently, you will have to monitor these "recurring services" for the effectiveness and quality, either to increase the payment or lowering it to the service provider. Such adjustment have to be as far as possible objective and not subjective, but one cannot 100% eliminate subjective qualifications. This no doubt will warrant changes to the present periodic broker review process within asset managers.
If the recently leaked MiFID II documents are to be given any credence, it would suggest the use of commission dollars to pay for research is not entirely likely to be banned under the newly proposed MiFID II guidelines. However, de-linking research payments from value and volume of trade execution is here to stay, in all likelihood. The newly revised draft language seems to suggest that Commission Sharing Arrangements (CSAs) may be allowed to continue under the new regime; albeit in some reformed manner. All of this suggests a slight climb down from the previous extreme view that all research and related services would be disallowed for payment using trade commissions.
Payouts for research services undoubtedly will remain under pressure, especially as long as active managers fail to outperform passive funds. We believe MiFID II and the moves to make commission usage more accountable in other jurisdictions, will all put pressure on the research industry. Therefore research service providers have to think hard about their service proposition, product offering and productivity and technology needs. We believe that sell-side research service providers have to look at their technology infrastructure in order to deliver on their client expectations in the evolving market place; while minimizing cost of service.
While the purpose of MiFID II in the context of research and research related services has been to create transparency and a more competitive market structure across Europe, we wonder if the unintended consequences of many of these moves will deliver quite the opposite result, when it comes to the market for research and research related services.
Asset Managers have always been sensitive to the needs of their larger global research service providers, given their reach of coverage as well as (although never publicly admitted by asset managers) their ability to deliver allocations in successful IPOs. Consequently, the contraction in the research market (in revenue terms) could come at the expense of the smaller more marginal players, as the global banks and service providers, are disproportionately "protected" as a result of their "other benefits" brought to the asset managers. This could lead to further concentration of the sell-side research industry in the hands of a few global service providers (i.e., an oligarchic market structure), with mid-size and smaller research service providers feeling more of the revenue squeeze. This is not the outcome that regulators would like to see; so a lot would depend on the exact contours of the new regime and how they will ensure such oligarchic market structures are prevented from taking shape.
Broker-dealers, investment banks and independent research providers all have to look at their value proposition closely and align their resources to provide a cost effective service to asset managers. Competitive pressures will remain and therefore value proposition to build sticky customer relationships is going to be vital for sustainability.
We believe asset managers will also have to evolve the ways in which they assess their research service providers when it comes to either putting them on their list of "approved" service providers, or how they pay for these providers.
If the regulatory mandate is also to create a level playing field between broker-dealers, investment banks and independents, then careful attention has to be paid to ensure there are no cross-subsidization taking place in broker-dealers and in particular investment banks when it comes to pricing their research service (to asset managers), as invariably that would be hurt the independent research industry.
