MIFID-II - Are the new Research 'unbundling' rules actually harming the people they are designed to protect?

MIFID-II - Are the new Research 'unbundling' rules actually harming the people they are designed to protect?

What is MIFID-II?

The Markets in Financial Instruments Directive (MiFID) came into force on 1 November 2007 and impacted all Europe financial markets. In October 2011, the European Commission published its legislative proposals, which took the form of a revised Directive (MiFID II) and a new Regulation (MiFIR) covering research rules (which this blog relates to), cost/charge disclosure reporting, best execution around trading, handling client money, transaction/trade reporting, offering advice, internal governance (around conflicts of interest, inducements, product governance, etc) and the classification of clients.

Background to the new research rules

From 3rd January 2018, under MiFID-II, the investment research business entered a ‘brave new world’. From this date, investment research needed to be priced and charged for separately (or ‘unbundled’) from execution fees. This is because, under MiFID-II, the receipt of 3rd party research could be viewed as an inducement. Also MiFID-II has various demands about firms being fully transparent.

Consequently managers have had to make a key strategic decision to either pay for the research themselves (called “hard”) or to pass the costs onto their clients (called “soft”). Not unsurprisingly, the majority of firms have gone down the “hard” route. This is because firms do not want to appear to be passing extra fees onto clients. Furthermore as more and more firms have gone done the “hard” route then nobody really wants to appear as an outlier.

This change will have a number of impacts.

Short term (mainly operational and implementation) impacts

The majority of the short term impacts are mainly around the operational impacts of implement these changes; namely:

Firstly a large amount of operational change was required to support the new model. This covered (a) new processes, (b) training research users on what research they can use, (c) implementing new technology to track research usage, (d) implementing even more new technology to block unsolicited research as well as (e) implementing new accounting procedures to track financials.

Secondly a large number of legal contracts needed to be put in place between firms and the research providers (who all had differing commercial and pricing approaches just to make things more complex).
To be far; with such a large industry wide change then these issues, while painful, are not unexpected. Hopefully they should start to iron themselves out over the next year

Long term impacts

The long term impacts are much more interesting and worrying.
By funding research themselves, firms could treat research as any other business cost (such as technology, headcount, rent, etc.) which means it could it be ‘managed’.

While this is not always a bad thing because removing any unnecessary costs or overspend is always good but it could have a negative impact on investment performance for clients (i.e. the people that firms and the regulators are supposed to be looking after!).

A reduction in spend could mean that research providers focus on the larger and (easier?) areas of research such as macro and large cap. This means that there is a reduction in the amount and in the quality of research in ‘niche’ areas such as small cap, new technologies or emerging markets.

The end result is that the pool of available research is reduced and/or its quality goes down which means there is less data to input into investment decisions which could then impact investment performance for clients (again the the people that firms and the regulators are supposed to be looking after).

Therefore one could argue that this regulation (and how the market is implementing it) could actually end up harming the people it is supposed to be protecting?

I hope that you find this useful? But please feel free to comment especially if you have differing experiences and/or views?

© Paul Taylor 2018