**Title: The Impact of Financial Regulations on Equity Research and the Future of the Industry**
**Introduction**
The world of equity research has witnessed significant changes in recent years, driven by regulatory efforts to increase transparency and address conflicts of interest. The European Union’s Markets in Financial Instruments Directive II (MiFID II) implemented in 2018 aimed to separate research fees from trading commissions, transforming the way fund managers access and pay for research. However, unintended consequences of these regulations have emerged, leading to a reevaluation of the current framework. In this article, we will explore the effects of MiFID II on the financial ecosystem and delve into the future of equity research in light of regulatory changes.
**The Unintended Consequences of MiFID II**
1. Diminished Supply of Equity Research: While MiFID II brought greater transparency to the industry, it also inadvertently resulted in a decline in the supply of equity research, particularly for smaller companies. The directive triggered fierce price competition among large brokerage firms, causing small independent research institutes to suffer from plummeting prices for their services. As asset managers sought discounts, high-end brokers responded by offering all-inclusive research packages at significantly lower prices, leaving independent researchers struggling to compete.
2. Increased Costs for Investment Banks: MiFID II not only affected independent research providers but also imposed additional administrative burdens on large investment banks. The separation of research and trading fees added layers of complexity and administrative tasks, turning research into a substantial cost center. Amidst the challenges, some search managers found solace in the potential reversal of the previous system.
3. Budget-Conscious Customers: While research remains a significant aspect of investment decisions, customers have become more budget-conscious. MiFID II’s transition from an “all-you-can-eat” model to an “à la carte” approach prompted investors to analyze their research consumption more thoroughly. As the cost of research became explicitly stated, asset owners began questioning the allocation of these expenses, paving the way for changes in payment structures.
**The US Approach and Potential Solutions**
1. Historical Coupling of Research Costs: In contrast to Europe, the United States has traditionally coupled research costs with trading commissions. The US Investment Act of 1940 prohibits professional investors from directly paying for research. Recent concerns regarding the need for US intermediaries to establish special investment advisers to accept direct payments under MiFID II have subsided, offering stability in the US framework.
2. Flexibility in Payments: In the UK, a government-commissioned review by financial services lawyer Rachel Kent recommended embracing more flexible payment structures rather than mandating a return to commission-sharing arrangements. While Europe and the UK will not revert to the pre-MiFID II regime, the proposed flexibility aims to strike a balance between cost management and quality research.
**The Future of Equity Research**
Looking ahead, the equity research industry continues to adapt to regulatory changes and evolving customer demands. Here are some perspectives and insights on the future of this dynamic field:
1. Collaboration and Differentiation: Independent research groups do not expect a sudden and dramatic improvement in business prospects. However, they recognize the need to collaborate with larger institutions and differentiate themselves by providing unique insights and specialized research offerings. By leveraging their expertise and nurturing client relationships, these groups can carve out a niche in the evolving landscape.
2. Technological Advancements: The future of equity research is intricately linked with technological advancements. Innovations such as artificial intelligence, machine learning, and data analytics have the potential to revolutionize the research process, enabling analysts to generate insights more efficiently and accurately. Embracing such technologies can enhance research quality and differentiate providers in an increasingly competitive environment.
3. Evolving Business Models: As the industry adapts to the changing landscape, traditional business models are being challenged. Subscription-based models, unbundling of services, and alternative pricing structures are emerging as potential solutions to the challenges posed by MiFID II. Providers need to explore innovative approaches to ensure sustainable growth in a new era of research consumption.
4. Value of Quality Research: While cost considerations are vital, the importance of quality research should not be undermined. Thorough analysis plays a crucial role in informed investment decision-making. As asset managers navigate the shifting regulatory landscape, the question of who bears the cost of research remains crucial. Striking a fair balance between clients and asset managers is essential to sustain a vibrant equity research industry.
**Summary**
In summary, the implementation of MiFID II significantly transformed the equity research landscape, bringing increased transparency but also unintentional consequences. The separation of research fees from trading commissions disrupted the industry, leading to diminished supply and lower prices for independent research providers. Investment banks faced increased administrative burden while asset managers became more budget-conscious. However, the future of equity research holds promise through collaboration, technological advancements, and innovative business models. The focus on providing high-quality research and finding a fair distribution of research costs will shape the industry’s trajectory. As financial regulations evolve, staying informed and adaptable will be key for both investors and research providers seeking success in an ever-changing landscape.
*Sources:*
– Alan Livsey, “The unintended consequences of Mifid II,” Financial Times, [link to the article]
– Mike Carrodus, Substantive Research
– Iain Johnston, President of New Street Research
*Keywords: equity research, MiFID II, financial regulations, transparency, unintended consequences, independent research, investment banks, budget-conscious, payment structures, future of research*
The content above provides a comprehensive overview of the impact of financial regulations, specifically MiFID II, on equity research. It dives into the unintended consequences of the regulatory framework, examines the contrasting approaches in the US, and explores potential solutions and insights for the future of the industry. By addressing crucial aspects and offering unique perspectives, this article aims to inform and engage readers seeking a deeper understanding of the evolving research landscape.
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Decades ago, when I was a sales analyst in the City of London and making the rounds to my firm’s fund management clients, I regularly asked them a simple question: what did they want from research?
The answer then was: every option imaginable. Fund managers’ desks were often overflowing with growing piles of unread research and their phones were besieged by brokers brimming with ideas. But investors wanted even more. Why? Because the direct cost to them was minimal. All of this was largely paid for with transaction commissions. In turn, these were paid from the pockets of the fund manager’s clients: pension funds and the like.
Ultimately, regulators thought it wasn’t a great idea and along came Europe’s much-heralded Markets in Financial Instruments Directive II – or Mifid II – of 2018. This aimed to shed light on research fees by separating commissions research from trading commissions and making the costs explicit.
Now, however, regulators are implementing what in my current profession is known as “reverse ferreting.” Spurred by the UK Treasury which is looking to take advantage of its post-Brexit freedom from EU rule-making, regulators at the Financial Conduct Authority have begun to reconsider this separation of research and trading fees. The European Securities and Markets Authority is carrying out a similar exercise.
The main driver of this extraordinary turnaround is the awareness of the unintended consequences that Mifid II has produced. The directive has undoubtedly brought greater transparency. But there have also been complaints that the changes have damaged the financial ecosystem and diminished the supply of equity research, particularly for smaller companies.
Initially, Mifid II disaggregation promised a tool to promote higher quality analysis and reduce any redundant reporting. But it also began a period of ferocious price cutting on research by the largest brokerage firms.
As small independent research institutes watched in horror, prices for their services plummeted. Asset managers, who found themselves having to pay more explicitly for research costs, gladly seized any opportunity for a discount. High-end brokers have faced any competition from independents with all-inclusive research packages at very low prices.
And even for large investment banks, Mifid II had disadvantages. It added layers of administration to win the search battle. Regardless of any subsidies provided by other parts of investment banking, research has become an even bigger cost center than it previously was.
“I think quite a few search managers will be happy to see the previous system go,” says Steve Kelly, a consultant at the European Association of Independent Search Providers.
Research remains big business. Global cash equity research was estimated to cost about $11 billion a year last year, according to Kelly’s analysis of Integrity Research data. About $6 billion comes from the United States, while Europe and the United Kingdom provide about $3 billion. But search customers have become more budget-conscious, even in the United States. “When you move from an all-you-can-eat model to an à la carte model, you think more carefully about what you consume,” says a senior executive at a large US fund manager.
In the United States, the investment community has long coupled research costs with trading commissions. According to the US Investment Act of 1940, professional investors cannot pay for research directly. Local concerns that US intermediaries would have to set up special investment advisers to accept direct payments under Mifid II have recently been put to rest. An alternative solution would leave all the money paid for British and European research seized in that region.
In Europe, things will not return to pre-Mifid II times. Even in the UK, a government-commissioned review by financial services lawyer Rachel Kent did not recommend a mandatory return to the commission sharing (through trading) arrangements of the past. But Kent suggested that more flexibility in payments is needed. Nor do independent research groups expect business to suddenly and radically improve. “I would expect perhaps a 5-6% increase in our global revenues,” says Iain Johnston, president of New Street Research.
After seeing the government backtrack on MiFID II for research, many investment managers will want to delay discussions on costs until the changes are confirmed. Such discussions will undoubtedly be complicated. If their clients expect their asset managers to perform thorough analysis, shouldn’t this cost be shared?
When considered as part of trading expenses, the cost can be as little as a few hundredths of a percentage point. Not so fast, asset owners might say. Mike Carrodus of Substantive Research jokes that pension fund executives ask, “If it’s so little, why don’t you pay for it?” Who shells out for research, not just how much, is the real issue.
alan.livsey@ft.com
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