Joshua Maxey, (pictured) Managing Director, Third Bridge, sets the scene on the postponement of MiFID and its implications for investors.
On 11 February, the European Commission confirmed it will be delaying the implementation of the MiFID II and MiFIR directive, across the European Union, until 3 January 2018. Naturally, it came as a relief to many sections of the investment industry, who now have another year to make the necessary changes to their systems. However, the same cannot be said for investors.
The directive was announced with a plethora of key objectives, and one in particular for the investor community: to clamp down on trading commission bundling. The belief is that by forcing brokers to price and charge for services separately, this will enhance transparency and accountability, and achieve both better execution and better use of client funds to pay for “substantive” research. With this delay to implementation, it should be investors crying foul – it is they who risk spending money that does not deliver.
What is broken with the current model?
Currently, commissions charged on trades between the buy and sell-side are bundled, meaning part of the fees are used to pay for the execution of the trade and the remainder is attributed to “research”. This research component can include anything from access to meetings with the management team of public companies (non-deal roadshows), attending conferences organised by the sell-side, consuming written research, or receiving automated voicemails with earnings updates. The size of this market is estimated to be anywhere in the region of USD5-9 billion annually, funded by investors, so it’s no surprise the regulators are spending a vast amount of their time looking at this more closely. It’s also worth mentioning that the FCA in the UK has been leading the charge over the past decade to “unbundle” commissions and we are now in an environment where investors expect to see greater transparency on the attribution of commission fees.
The current status quo is that equity research, written by sell-side banks, helps buy-side analysts with their investment decisions. However, in reality, we feel this relationship adds little value to buy-side intelligence. With the nature of research today, sell-side analysts tend to follow quarterly earnings trends and try to justify their existence by pushing as much product (research notes, voicemails, and corporate access) to the buy-side to generate trading commissions. The short-term nature of this negatively impacts the quality of the research, leaving little time to provide insight on long-term thematic developments that could truly inform buy-side intelligence.
The debate that continues to be challenging for most players is what price tag to put on such services. We continue to hear stories of large equity trading desks from major investment banks asking the buy-side to commit to a minimum annual spend of USD3 million for research commissions without providing detailed clarity on what this service gets you. No wonder investors feel unfairly charged.
How MiFID tries to address the issue
For this reason, MiFID II argues that clear research budgets need to be agreed in advance and made publicly available. If the allocated trading commissions are larger than the allocated research pot, the difference is credited back to investors at the end of the year.
Furthermore, buy-side firms will have to justify their choice of research services and demonstrate the value it provides. This means providers will have to quote a hard price for their research and make their pricing structures transparent. To clarify, regulators have no issue with the buy-side paying for research; they only ask that the research be clearly priced.
As research quality comes under increased scrutiny, widely-distributed generic research will also be considered of lesser value. Where bigger firms will need to focus on differentiating their research offerings, mid-tier brokers could benefit from the opportunity to become high-quality research specialists on small or midsized companies.
Encouragingly, the impending legislative effect has ignited the research industry again, and this will open up more opportunities to grow market share in a sell-side dominated pool. More participants in the market can only be a good thing for the investor, and it will be interesting to watch the market shift in the run up to the latest deadline.
What impact will research unbundling have on market participants?
Looking ahead to when the changes are enforced, costs will become more fixed, meaning the investor will know exactly what their money is paying for. This is rarely the case today, especially with the prevailing voting system, where the analyst votes for his or her favourite broker. This results in a misalignment between the value of research, and how much is actually “paid for research”. It’s an unfair situation, and one the investor will, at times, be unaware of.
A part of investment banking rarely discussed in the media is prime broker services. Sell-side investment banks provide services for hedge funds that enable them to bet against stocks by lending shares to the fund, and provide general market making services. It is the usual practice to bundle in other services as a part of this offer, such as consulting, or helping the fund with operational issues. However, the problem arises where fees paid to the prime brokers come out of the fund expenses, in other words the investors’ pockets. When that happens we end up with a situation where these ancillary services are “bundled” rather than priced into a trading relationship. This has ultimately buoyed the regulators’ push for increased transparency and we expect prime broker services to be either abandoned altogether or priced like a consulting firm with a transparent fee schedule.
In the future, buy-side investors will know exactly what they are paying for, and can assess the fees and results accurately. Although this will naturally increase the administrative burdens on the buy-side; critically it will result in a greater strengthening of their fiduciary duty to their clients. This will always be welcomed by investors.
The directive has the potential to transform the landscape, particularly driving greater accountability within the sector on the true value of market research. When enforced, it’s set to shake up the current status quo of the voting mechanisms used by buy-side managers that often leads to a bias allocation of votes. The delay in enforcement only risks agitating the independent research community who are set to benefit the most from this.
Investors deserve to know what they are paying for, and we look forward to having a clear guideline framework in place that mandates what you can and cannot pay for using dealing commissions.