What’s Mifid II and why do we need it?
It’s a game-changer. And like a lot of modern financial regulation, you can thank the G20 Pittsburgh meeting in 2009 for it.
In 2014, the Markets in Financial Instruments Directive (Mifid) II was pitched as an update to 2004’s Mifid, but it quickly became clear that it would be so much more than that.
There was a lot of criticism of the way financial markets were regulated in the period following the crisis. Action had to be taken to protect everyone involved, from the markets themselves and the systemically important institutions that operate in them, right down to the end consumer.
So Mifid II touches practically every corner of the finance world, whether it’s in the form of new product governance rules that protect retail investors to highly technical distinctions between different types of trading venues and instruments. The UK regulator even tried to force advisors to tape all order-based telephone calls and hold onto the recordings for five years, though that was later pared back to just note-taking after industry pushback.
It’s a mammoth task. A task so huge in fact, that much to their dismay, European regulators have already been forced to delay implementation by a year, to January 3 2018. Without wanting to dash the hopes of too many in the market, it’s not going to be delayed again, so now Mifid mania has set in. Firms have appointed entire teams to deal with the new directive – City research provider Peel Hunt has put 10% of its entire workforce on its Mifid II taskforce.
Implementing it has been difficult because of the very makeup of the EU. Mifid II is a directive, not a regulation and so member state authorities have considerable freedom when transposing it into national law – but more on that later. It has got an accompanying regulation, Mifir, which admittedly hasn’t made as many headlines. That could be because the acronym doesn’t have the same satisfying ring to it – but it also could be because the directive is where most of the meat can be found.
How does it affect investment research?
At the moment, research doesn’t have an official cost. Buyside firms pay investment banks a fee which includes charges for both execution and research, all bundled up into one tidy sum. In fact it’s often said that many fund managers think research is free – but think of that what you will.
So, regulators want the buyside to establish research payment accounts (RPA), which introduce additional reporting, disclosure and auditing requirements and enforce an absolute research budget.
Asset managers will be required to either create RPAs funded by client money, pay for the research themselves, or stop buying research altogether. According to Vincent Dessard, senior regulatory policy advisor at the European Fund and Asset Management Association, they’re all suitable – what firms opt for will be a fundamental business decision rather than a regulatory one.
At the moment, many firms use a commission-sharing agreement (CSA), a sort of middle ground between bundling and unbundling that sees managers pay a portion of the funds to brokers for execution with a separate portion allocated to a research provider. CSAs’ post-Mifid II future is not yet clear, though the hope is that they will be permitted.
By tackling such a longstanding tradition that’s become so ingrained in market practice, the changes have prompted some philosophical questions about what research actually is and what each piece is worth.
So what is research?
According to the delegated act put forward by the European Securities and Markets Authority (Esma):
‘Research in this context should be understood as covering material or services concerning one or several financial instruments…and provides a substantiated opinion as to the present or future value or price of such instruments.’
This means that, aside from a limited number of exemptions, the rules apply to all forms of research, be it equity or anything else. That includes written notes and both calls and meetings with analysts.
According to lawyers, most clients don’t find much value in the regular, general investment notes churned out by banks and distributed to everyone on the mailing list. The FT says just two to five percent of all research emails are read each week. What’s really valuable is targeted, individually tailored information that usually comes from one-on-one time with an analyst.
Another thing banks can offer their clients is access to the corporate executives and officials the research is covering. It’s easy to see how this creates conflicts; if analysts are being paid for how many buyside/corporate meetings they can arrange then there’s an incentive to keep the research reports on said corporates fairly sweet to maintain the relationship. Plenty of research – yes, research about research – has found that analysts are routinely a bit too generous about the companies they cover.
And that’s not the only conflict. In regulators’ eyes, offering so-called monetary benefits like corporate access is an inducement to trade with the bank. Inducements will be banned under Mifid II, except where they are found to be a ‘minor non-monetary benefit’ – though just what that is is keeping plenty of people up at night.
There was some uproar in late 2016 over whether or not macroeconomic research is considered research by Mifid II. That fire was fuelled by consultations by UK and French regulators, released within weeks of each other, which took considerably different positions. Cries of Brexit-themed one-upmanship prompted Esma to release a Q&A on the topic. The authority concluded that it will depend on the nature of individual pieces of analysis but that, as a starting point, this type of research ‘is likely to, explicitly or implicitly, suggest an investment strategy’ – though exceptions can be made for generic information that’s publicly available.
What’s everyone doing about it?
Slowly but surely, firms are announcing how they plan to price and/or pay for investment research. Some, including JP Morgan’s asset management division, M&G, Vanguard and Jupiter have said they’ll pay for all research out of their own profit and loss accounts. It might be the easier option to accommodate client needs, which are of course likely to differ.
“What happens if client A wants a research budget of $10, and client B wants one of $50? Does client A get the research benefit anyway? The portfolio manager can’t exactly split their brain,” said Sidley Austin partner Leonard Ng.
But for others that just won’t work. Of the firms that have announced so far, it’s a fairly even split, with Amundi, Janus Henderson, Schroders and Man Group all continuing to pass the cost on to clients.
Costs are being announced too – in early August UBS said it planned to charge clients around $40,000 per year to access basic equity research after Mifid II, and an entry-level deal with Barclays would set you back a similar amount. Other sources suggest that good analysts could charge up to $5,000 an hour.
What’s good about it?
Well, that depends who you ask. The apocalyptic claims have died down a bit now, but there’s no denying the new rules will have a huge impact on the way research is bought, sold and consumed.
For independent research providers (IRPs), it looks like it could be pretty good. Glenn Bedwin, a board member for trade association Euro IRP, told IFLR that Mifid II’s research provisions will level the playing field. IRPs have always had to be clear on how much each piece of research costs, so the new rules should cut through the monopoly investment banks currently have on the market, and improve the quality and efficiency of the entire system.
The future is possibly less rosy for research analysts working in banks. In-house research divisions have already shrunk significantly, starting with the accusations of biased research that led to the dotcom bubble. More extreme predictions foresee thousands of bank analyst redundancies in the coming years. That might be a slight exaggeration. But even so, every market poll on the topic – and there’s been a lot of them – has found that virtually every buyside firm plans to scale back its usage of investment bank research in some way once the rules bite, so there’s bound to be opportunities for new entrants and smaller players.
It’s hard to argue with the fact that the existing system was a bit of a muddle. The UK, serial gold-plater of EU rules, has been asking firms to price and sell research separately from execution since 2007.
By creating more competition and scrutiny of potential biases, Mifid II should, in theory, improve the quality of investment research in general. Bedwin has no doubt that that’s the case.
What’s the deal with non-EU countries?
That’s one of the main problems. While most are used t0 the US’ long arm of regulation, they’re not too happy about it being mirrored on the other side of the Atlantic.
Its research unbundling provision is one of the main ways in which non-EU firms will be caught by Mifid II. EU firms will have to pay for all research independently of execution – regardless of their brokers’ home jurisdiction. Global investment groups are rumoured to be rolling out a global plan for research unbundling in the interest of consistency, so even if you have no relationship with an EU client or counterparty, chances are you won’t escape it.
An IFLR poll conducted last month found the research unbundling provisions to be the biggest Mifid II-related headache for Asian market participants. Those same sources have told IFLR journalists that the new directive threatens to disrupt regional capital markets at a critical time in their growth in such a way that could cause permanent damage.
It’s also causing big problems in the US where, under federal law, brokers can only provide research as a service associated with execution. If not they have to register as an investment advisor – which is not as straightforward as it might sound and could cause havoc for brokers’ business models. The Securities and Exchange Commission has already acknowledged, albeit reluctantly, that something may have to be done, possibly in the form of a no action letter to provide relief on certain points.
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