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Long Story Short – What is MiFID II and why does it matter?
Effective as of January 3, 2018 in the European Union, the Markets in Financial Instruments Directive (MiFID) II is a legislative framework that builds upon MiFID I (put into force on November 1, 2007) to regulate financial markets in the EU and to improve protections for investors. MiFID II covers nearly all aspects of financial investment and trading affecting nearly all financial professionals within the EU. A key element of MiFID II is the unbundling of research costs from trading/execution costs. Traditionally and to a large extent currently in the U.S., institutional money managers received access to the investment research of Wall Street brokerage firms as part of doing business with the firm, oftentimes via directing trading activity through such firms. MiFID II requires fund managers in the EU to either pay for research themselves or to set up a research budget account, where the budget has been agreed with the client.
MiFID II, however, is not compatible with existing U.S. SEC regulations, which prohibits funds from paying cash to U.S. brokers for investment research. This has created some conflict and confusion among investment managers, particularly those with operations that fall under the EU directive. In 2017, the SEC issued three no-action letters allowing U.S. broker dealers to comply with certain MiFID II research unbundling requirements when they are doing business with European investment managers. This relief expires in July 2020.
Increased Transparency. Prior to MiFID II, the cost of equity research was buried in the overall execution costs. This cost has now become transparent enabling buy side firms as well as their customers to more directly determine if the benefits are worth the costs.
Increased Competition. Due to the unbundling of research, a number of big investment banks like JPMorgan have slashed the prices charged for analyst research in an attempt to gain market share. In this way, increased competition among investment banks appears to have a positive impact on investors in the form of reduced costs.
Reduced Research Budgets. Frost Consulting reports equity research budgets have declined from a peak of $8.2 billion in 2008 to $3.4 billion in 2017. According to a Tabb Group report, since the implementation of MiFID II, there has been a 40% cut in the research portion of the commission wallet. In addition to cutting back on research, buy side firms are now executing with a much smaller number of broker-dealers. Where once a buy side firm may have traded with 200 firms, they are now trading with a dozen, further concentrating the business.
Reduced Research Coverage. As a result of the cut back in research spending, coverage of mid and small caps is declining. “Mid and small-caps in Europe have fewer and fewer brokers following them,” says Laurent Quirin, chairman of Kepler Cheuvreux. A corollary to the decline in coverage is an increasingly pertinent question of small companies as to whether coming public makes sense.
Negative Impact on Smaller Investment Firms. Some 86% of participants in a recent EvercoreISI survey believe MiFID II is having a negative impact on small-to-mid sized broker-dealers, with 79% of respondents believing there is a net negative impact on small-to-mid sized asset managers. The smaller asset managers are being placed at a competitive disadvantage to their larger brethren who can more easily afford to pay for research or further develop in-house research sources. The smaller broker-dealers are seeing their revenue sources dry up, both via a reduction in trading commissions as asset managers direct trades through a smaller number of firms and via an ongoing reduction in research pricing as larger firms seem intent on a race to the bottom to gain market share.
Loss of Liquidity. Nearly one-half of buy-side traders surveyed believe that equity liquidity had become harder to source since the implementation of MiFID II. Some investment firms have stopped offering trading in EU-based markets because of its low levels of liquidity leading to a vicious cycle.
Limited Impact, if any, in the U.S. The impact of MiFID II may be limited in the U.S. According to an EvercoreISI survey, only 5% of U.S. money managers believe that U.S. regulators will implement MiFID II research unbundling rules anytime in the next five years. However, although the regulation may not be forthcoming, 70% of these same money managers believe the U.S. will experience de facto unbundling through the growth of commission sharing arrangements (CSAs).
The CBA of MiFID II is underway. In the U.S., the impacts of MiFID II are slowly being felt especially among larger, international-oriented firms. More transparency is always favored over less transparency in the investment business. But at what costs? According to a study by Frost Consulting, the magnitude of research spending by money managers is usually less than 10 bps, which is dwarfed by average long-term equity returns, 700 bps annually. Notably, asset managers using client money to pay for research are spending multiples compared to those firm’s pay out of pocket for research. And, at least according to the Frost study, those using more research are significantly outperforming those firms that are using less research. The jury remains out on if the benefits of MiFID II will outweigh the costs to investors.
MiFID II, Will Kenton, Investopedia, April 26, 2019
MiFID II Increases Research Unbundling In US, Markets Media, Shanny Basar, April 23, 2019
Mifid II has thrown up several unintended consequences, Murphy, Morris, & Mooney, Financial Times, January 1, 2019
U.S. asset managers shake up equity research as banks cut back, Trevor Hunnicutt, Reuters, February 5, 2018
MiFID II Research Unbundling Spreads Uncertainty to the U.S., Ivy Schmerken, FlexAdvantage Blog
Mifid II is hurting, but there is no way back, Dominic O’Neill, December 11, 2018
MiFID II Increases Risk of Research Underspending – Performance Implications?, Integrity Research Associates, Neil Scarth, October 17, 2018