Original article published in the WMA Journal.
In this article we give an insight to how the Markets in Financial Instruments Directive II (MiFID II) will change the whole financial research landscape.
Little has happened to financial research since email replaced the fax machine, but that is all about to change and quite significantly. In what is expected to have the biggest effect on the industry since the Big Bang, EU-wide regulation is unbundling research from execution.
With the introduction of the Markets in Financial Instruments Directive II (MiFID II) banks now have to put a price on their research. If buy side firms want to continue to receive research, which is no longer free, they will need to pay explicitly and begin to consume research in a fully compliant way. While there is a lot of detail, what is most apparent is that the FCA expects significant changes to policies, systems and even business models as a result of MiFID II.
Why has this happened?
The regulator has decided that the bundling together of research with execution is an inducement to trade. The more banks sent, the more they expected back from their clients. Paying an all-in commission rate to receive that research meant that buy side firms weren’t seeking out best execution for their end investors. Instead, they were likely to trade with banks who produced the most and possibly the best? research.
What does it mean for you?
There is a lot of detail available now on what the new rules of engagement are. The FCA release their consultation paper at the end of September producing some much need clarity. By sheer size, the FCA report is nearly 600 pages long. However, the relevant section relating to research unbundling is just 10 pages. The principles are simple:
- Separately and explicitly pay for research
- Set a research budget
- Block any research you haven’t paid for
- Monitor what you consume
- Rate the quality of the research you use
- Have management oversight
- Report to investors on how you’ve used their budget
Is this just for equities?
No, the new research rules apply to all asset classes covered under MiFID II. As a result, unbundling is not just an “equity issue.” Economics, commodities, even real estate research will need to be paid for.
How much is it all going to cost?
Well, we’re still waiting for the banks and& brokers to put a price on their research but there are 1000s of non-broker research firms who have been pricing their research for years, if not decades. Their pricing will help in price discovery but it’s not just the level that will emerge. How research is packaged is also something to look out for - is there one price for everything from a bank or will research be available by asset class or sector?
What about all the emails in my inbox?
One of the biggest challenges of continuing to read research from your inbox is the need to monitor consumption of research. It’s quite hard to do from a PDF attachment. The bigger challenge is actually blocking research that you haven’t paid for. Freeing up your inbox and moving to a cloud-based aggregation platform gives you the tracking and blocking required while making research reports easier to find and search.
Will small and midcap research disappear?
There will definitely be some structural changes in the market but it’s more likely that some of the 50+ research providers covering Vodafone will find a new focus in life. Some of them may choose to cover less liquid, smaller stocks where they are able to sell their research for a similar price. There will be a place for waterfront coverage but there will also be interest in niche providers. Ultimately, demand should balance out supply.
What do investors need to know?
Keeping in line with increased post-trade communications which appear elsewhere in MiFID II, asset managers will be required not only to set and communicate budgets in advance, but also to inform clients of the total amount actually spent on research. Beyond accounting, firms will also need to keep track of the goods and services received. This requirement will mean material changes on how research is received, consumed and monitored by the buy side and the creation of audit trails for research providers’ payments.
I have a CSA, is that enough?
A new way of paying for research has been introduced, the Research Payment Account (RPA). Investment firms will set budgets at the strategy level and then make payments from one RPA per budget. The budget can be funded by a direct fee to the investor, most likely charged alongside the existing management fee. CSAs can still be used to fund an RPA but there are now stricter rules in place.
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