International Financial Law Review
By Amélie Labbé
31 January 2018
The days of investment research as we know it could be over if recent developments in the market are looked at more closely.
The new Markets in Financial Instruments Directive (Mifid II) aims to democratise the research process by separating this provision from the execution of a transaction: put simply, this means payment for research cannot be linked in value or in volume to the placing of a trade.
The separation of the research from the trade execution is a drastic move for an industry that has historically relied on seemingly free and abundant investment reports as revenue from the trade was used to fund the research.
Both fund managers and research providers have felt the consequences of this unbundling, not least because the new rules mandate more transparency on how research is priced, what it covers and who exactly is paying for it.
A number of fund managers, including JP Morgan and Baillie Gifford, announced last year they would absorb the cost of providing research, while others such as Schroders said they would pass the cost on to their clients. But no clear-cut solution has emerged.
Overall, the reaction to the Mifid II rules has been mixed: one market participant told IFLR there was a flurry of decisions from the buy side on how to deal with research in Q3 and Q4 of last year as organisations scrambled to comply, which didn’t leave a lot of time for implementation.
Paying the price
Two models have emerged that comply with Mifid II requirements: the profit and loss statement (P&L) model, where the buy side pays for research into a financial instrument, company or market itself; and the research payment account (RPA) model, under which the buy side uses client funds to pay for the research. Initial data suggests that the P&L model has been the one that most sell-side firms have gone for.
That’s because the RPA model needs heavy infrastructure in place to function properly, to identify clients and to enable process confirmation.
According to a clearing market participant, the type of research model selected is ultimately determined by the type of buy side entity. “If you’re a mutual fund manager, it’s easier to come to a decision and work it out,” he said. “If you’re a pension fund manager, with lots of external third-party clients, you’re going to have some tricky conversations.”
- The reaction to the Mifid II rules has been mixed: there was a flurry of decisions from the buy side on how to deal with research in Q3 and Q4 of last year, which didn’t leave a lot of time for implementation;
- The type of product traded could also have an impact on the model chosen: it’s easier, for instance, to attribute specific costs for equity research, which is often focused on a single stock. It’s trickier for fixed income instruments such as FX or interest rate derivatives;
- A lot of research providers are feeling the pinch. Reactions have been varied: from some sellside entities winding up their research desks, to some of the larger players acquiring their smaller counterparts. Change is happening.
The type of product traded could also have an impact on the model chosen: it’s easier, for instance, to attribute specific costs for equity research, which is often focused on a single stock. When it comes to fixed income instruments such as FX or interest rate derivatives it’s a more complex situation.
As the main consumers of research, asset managers are expected to be directly affected by recent changes to the way research is priced, as the cost will be passed on to them in many cases (directly or indirectly). In practice, this impact has been visible in the way they have amended budgets allocated to research.
Arzish Baaquie, head of UK at Smartkarma, said that some asset managers have been caught somewhat off-guard and are undecided on the best way forward.
“It was expected before Mifid II came into effect that there would be a 25 to 30% cut to research budgets,” he said. “What we have heard is that although the average figure is around 25%, some funds are cutting their budgets by as much as 50 to 60%.”
According to a report by Greenwich Associates, the market for EU equity research has shrunk 20% from 2016, slashing some $300 million out of EU funds’ research budgets.
Winner takes all
It’s fair to say that investment research could ultimately be produced, as the value attached to it under Mifid II increases and costs start growing for the buy side. It’s expected that the investment research industry will undergo wide transformation as a direct result of the latest new Mifid rules. While a reshuffle of the sector has been in the pipeline for a while – the UK’s Financial Conduct Authority took steps in the past few years to introduce research unbundling – but Mifid II has been the main catalyst for change.
According to Baaquie, a lot of research providers are feeling the pinch. Reactions are likely to be varied, and could well result in some industry-wide ramifications: from some sell-side entities winding up their research desks altogether to some of the larger players acquiring their smaller counterparts; change is happening. In some instances, exchanges are interacting directly with the smaller, less visible (and less covered) companies to ensure they remain on investors’ radar.
The Financial Times reports that Paris-based trading platform Euronext publishes free research for 430 of its smaller companies through a partnership with independent provider Morningstar, and is looking at ways to increase this coverage.
There are also concerns that the reshuffle could lead to a race to the bottom, with some research providers charging very low fees, according to Gaurav Chandra, product manager at AxiomSL.
“Some banks have the infrastructure to charge a low price to keep the relationships with clients,” he said. “Independent research providers don’t have those resources.”
Some banks have stopped providing research altogether. In an interview with the Financial Times, the head of Japan’s Nomura, Koji Nagai, said the bank was not a charity and could not provide research services for free. “We already stopped providing research services in Europe. Probably there is no advantage in providing the service in the US,” he said.
On the buy-side, the smaller asset managers have been hit the hardest. “Not all the smaller asset managers can absorb the investment research cost and some will be forced to pass it on their clients. Unsurprisingly clients are asking why they are being charged research fees.”
Challenging the status quo
There has been a fair amount written about how Mifid II is affecting the financial sector by promoting transparency across asset classes and consumer protection, but part of its aim is also to re-size the research process. Its framework is centered on product governance and could make research more targeted to the needs of investors.
As published in IFLR.