The revised Markets in Financial Instruments Directive, MiFID II will come into effect in Europe from January 2018. The new legislative proposal is expected to have a global impact on the ecosystem of how buy-side consumes sell-side research. MiFID II provides several guidelines pertaining to transparency, market integration and investor protection. Governed by The European Securities and Market Authority (ESMA), some of the guidelines will include big changes to existing bundled payment structures. How will the new rules affect investment firms / sell-side firms, asset managers / buy-side firms, and research partners? Will there be more pain than gain for the industry?
A brief outline of the proposed changes relating to inducements and research payments to and from a third party can be found below:
- There will be a ban on non-monetary benefits.
- We will see the unbundling of “execution commissions” from “research commissions”.
- Additionally, an asset manager will only be able to purchase research from third parties, either by making payment out of its own resources or through a “separate research payment account”.
One of the main aims under the new rules will be to improve the way financial markets function by making them more efficient, resilient, and transparent. When it comes to sell-side research, there are two current models – bundled research payment model, where the broker holds all commissions and provides trade execution and other services, and commission sharing agreement research payment model which is a type of soft dollar arrangement between a fund manager and an execution broker.
Sell-side research is funded through commissions paid by clients each time they buy or sell shares. Research houses distribute large volumes of research to asset managers in the hope of winning future execution business from them. However, legacy systems of using dealing commissions, bundled with execution commissions paid out of clients’ funds presents some challenges. They do not guarantee whether a fund manager is paying for the right level of research, or receiving the best execution, if they automatically give business to a favoured research provider.
Seeking to address such conflicts of interest, MiFID II will affect the following stakeholders:
- Investment banks and sell-side firms – will need to restructure as research and trading services will become two independent business lines with separate profit and loss accounts (P&Ls), and return on investment (ROIs) targets. Under the new regime, cost and price of research would no longer be opaque and research content would need to be more differentiated and bespoke, in order to be successfully monetized. Consequently, sell-side analysts may be more willing to experiment with alternative data, technology and advanced analytics techniques to provide more insightful and timely research to clients.
- Asset managers and buy side firms – fund managers will have to pay separately for research services and charges won’t be able to come from trading commissions. The new guidelines will incentivize fund managers to rigorously assess value for money when purchasing third party research on behalf of their clients. Fund managers may start relying on data analytics that helps in selecting superior sell-side analysts / research houses.
- Third party research providers – as analysts will be more cautious about costs, there will be a bigger need for research innovation and value. Plus, to keep operations lean and profitable, third party providers who are cost-effective, provide high quality research, and embrace automation of routine tasks to meet the new requirements, may be used more and more.
- Companies under coverage – with research being sold as an independent product, there will be a greater incentive to expand stock coverage and research commissions. As a result, companies under coverage (particularly in the small cap and midcap universe) are likely to make changes to their reporting structure to be more responsive to analysts.
How will your business be affected by MiFID II? Our latest white paper looks at traditional payment structures and existing conflicts of interest, as well as the implications of the new market rules, both on payment models and on all market players across the financial industry.