The endeavours of European regulators to introduce greater transparency of costs and charges – to the ultimate benefit of end investors – via MiFID II has been harder to realise than policymakers may have anticipated. The unbundling of research and execution payments is a central part in this bid for transparency.
But rather than bringing costs of trading to the light, critics argue that the rules have had little impact on transparency, reduced research coverage and quality, and even dented liquidity of certain stocks.
For the buy-side, the way in which businesses source, consume and pay for research has been turned on its head as a result of unbundling. The rules mean that asset managers can no longer accept research that has been paid for through execution commissions and, after years of preparation, the majority of buy-side firms have opted to absorb those additional expenses rather than passing them on to the end investor. With the cost of research now directly impacting company P&L, research budgets across the buy-side have plummeted as attention shifts towards profitability.
A report on the impacts of unbundling from CFA Institute early this year found that larger buy-side firms are making the biggest cuts to budgets. On average, research resources have declined by around 6.3%, but for buy-side firms managing more than ¤250 billion, budgets have fallen at a higher level of around 11%.
Research quality is also perceived to have taken a hit since the regulation was introduced according to both buy- and sell-side participants surveyed by CFA Institute, as 44% of sell-side respondents indicated a drop in quality, although only 27% of buy-side respondents believed that was the case.
As sell-side institutions and research providers compete for these smaller budgets, coverage in less liquid stocks has also suffered. CFA Institute’s report found that very few respondents perceive an increase in research quality or coverage of those stocks under the MiFID II regime. Half of both buy- and sell-side market participants agreed that coverage of small- and mid-cap equities in particular has dwindled. The long-term unintended consequences of this is expressed as a major cause for concern across the industry.
Michael Horan, head of trading at BNY Mellon Pershing, says that the impact of unbundling on sell-side research, as well as the exodus of research analysts from sell-side institutions, was well-documented throughout 2018. But the most troublesome of unbundling’s consequences is the emphatically reduced liquidity across small- and mid-cap equity markets.
“Expenditure on small-cap research has decreased significantly, and coverage per company at the smaller end of the market has declined accordingly,” Horan says. “The squeezed research houses are putting their efforts into the larger liquid stocks, rather than the lower-ticket small caps which are typically more difficult, and now more expensive, to analyse.
“This creates two problems: much lower liquidity at the smaller end of the market – which we are seeing already – and more capital into large-cap stocks. This, combined with the broader shift to passive investments and continued inflows into ETFs and index tracker funds, is artificially increasing prices and causing investors to herd into large-caps.
“Lower liquidity in small and mid-caps has a number of potential implications. During periods of market volatility, such as the correction seen in ‘Red October’ in 2018, it makes it more difficult for traders and investors to unwind positions in what was previously a more liquid market, causing wider spreads and greater price swings. Over the longer term, a focus on large cap indices from both research houses and investors means we could see a hit to smaller company IPOs due to a lack of investment appetite, meaning fundraising will need to come from other sources.”
Inconclusive evidence
As the unbundling requirements have had over a year to bed in, some market participants are more critical of MiFID II’s failure to introduce greater transparency of costs thus far.
Considering the effects of MiFID II over 12 months into the regime, Chris Turnbull, CEO of research marketplace ERIC (Electronic Research Interchange), says that despite expectations that the regulation would unveil the true costs of research, pre-MiFID II behaviours such as deciding the value of research once it has been consumed, have not changed.
Turnbull believes that the UK financial regulator’s lack of input and enforcement of research unbundling has played a part in the slow progress of change.
“It is easy to see this as a disappointment and ultimately a signal of MiFID II’s struggles, but things are starting to move in the right direction,” he says. “A mitigating factor has been that the Financial Conduct Authority (FCA) has not been active enough in enforcing penalties and facilitating the transition. Firms have been given free reign, so it is unsurprising that some haven’t acted in the spirit of the regulation.
“The overwhelming majority of firms were unprepared for the changes last January, and the state of confusion continued throughout the year… We must now accept that achieving an effective research market will be a slow process, as we are very much in the infancy stage at this point. It could take five years for the regulation and implications of MiFID II to finally bed down across the industry, so we have a long way to go.”
On the other hand, the UK’s FCA has taken a very different stance on the implementation and impacts of unbundling in Europe. Speaking at the end of February, Andrew Bailey, the watchdog’s chief executive, proclaimed that MiFID II’s rules on payments and research have in fact had a positive impact on the industry so far.
He labelled evidence suggesting that research coverage for liquidity on smaller companies has been negatively impacted as ambiguous, despite the industry’s concerns.
“I think the evidence is, so far, inconclusive, and does not suggest the dramatically negative impact that some predicted,” Bailey said. “Overall, we consider that the rules are already having a positive impact. We are seeing changes in behaviour which are starting to deliver the intended effects – reducing conflicts of interest, improving accountability and producing cost savings for investors.”
Despite the relatively positive position the regulator is taking, Bailey added that the FCA – alongside the European Commission – is carrying out various studies on the effects of unbundling to address the concerns raised by market participants. Bailey said that the regulator is aware of and is looking into several concerns, including the impact on smaller firms and the apparent plummet in the price of research as the industry adapts to the new landscape.
For others in the industry, furthering the debate around the potential negative impacts of research unbundling is the most effective way of moving forward and navigating the complex issues of implementing such a far-reaching and global change. And the impacts of unbundling have indeed been global, with many global asset managers deciding to apply unbundling policies across regional businesses despite MiFID II being a European initiative.
“It is clear that the industry is still evolving as we adjust to unbundling research, particularly in different regulatory locations across the globe. As we as an industry adjust to the regulatory changes, the true value in research is also evolving as the introduction of technology in the research process is leading to necessary changes in the production and consumption of research,” says Mike Bellaro, CEO of not-for-profit equities trading consortium, Plato Partnership.
“The argument that research unbundling will lead to a decline in the number of analysts covering certain instruments or limit a company’s ability to engage investors is one viewpoint in a complex debate. As industry participants seek to differentiate in today’s competitive asset management industry, new alternatives are beginning to emerge which will challenge the traditional provision of research and construction of investment ideas, and the emphasis on supplier differentiation and move to quality over quantity is now firmly underway.”
Further consolidation
Looking to the year ahead, it’s likely that buy-side consolidation will be spurred on as asset managers, particularly the smaller firms, struggle to absorb the costs of research in the way their larger peers have done in order to remain competitive. This was one of the major predictions from consultancy firm Deloitte, which wrote in its regulatory outlook report for 2019 that smaller asset managers have seen less benefit from absorbing the costs of research than larger buyside powerhouses.
“Smaller investment managers enjoy fewer economies of scale when purchasing research, so have had to make a difficult choice between absorbing significant costs and asking their customers to pay. This new burden for smaller firms, along with other regulatory costs and competitive pressures, is likely to reinforce the trend of consolidation in the market,” Deloitte warned.
Even during the first year of the MiFID II regime, the industry has seen some interesting developments in terms of how firms are strategically managing the unbundling requirements. It’s clear that unbundling has forced certain brokers to revaluate their business models. MiFID II has shone a spotlight on execution performance and quality, forcing brokers to compete based purely on those merits, and as the buy-side shrink broker lists after recalibrating the costs of purchasing research, there’s evidence to suggest that the sell-side is beginning to specialise in either execution or research.
In November, US-based investment management and broker AllianceBernstein confirmed that it will acquire institutional research provider Autonomous Research. The move will provide Bernstein, the broking subsidiary of the $530 billion asset manager, with scale to expand and build its research business. Similarly, European equity agency broker Kepler Cheuvreux has honed in on its research business since the advent of MiFID II. The brokerage has inked several major research distribution deals with major institutions such as Piper Jaffray, Swedbank, UniCredit, Crédit Agricole CIB, and Rabobank, to raise its profile globally and expand its research client base.
The FCA’s chief concluded in his recent speech that unbundling has indeed been one of the most debated aspects of MiFID II, but overall the impact has been positive, with regulators around the world watching with keen eyes to see how this will play out. But perhaps the implied dip in research coverage and quality, as well as the impact for brokers operating in an unbundled fashion, is yet to be truly realised.
Bailey stated that the new framework has been designed to increase accountability and thus create a newly competitive market for research. But he reiterated that competition creates winners and losers. There’s no doubt that end investors have seen some financial gain as a result of unbundling, although the journey towards full transparency has only just begun.
With the buy-side facing further consolidation in the wake of rising costs, while the sell-side battles to win business amid increased scrutiny on execution performance and research quality, picking apart the end results of the research unbundling conundrum may take some time.