Thursday 13 April 2017 1:21 pmCFA Institute Talk

What’s wrong with MiFID II?

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Years in planning and one year late, the European Union’s wide-ranging new Markets in Financial Instruments Directive II (MiFID II) regulation will still catch out much of the industry.

While the aim — to fully and transparently align the industry with the end client — is worthy, the challenge is in implementation. Some areas remain unclear. What will represent best practice under the new regime? And is there a risk of regulatory arbitrage, with the MiFID II applied differently in each EU member state? For now, at least, the rest of the world will remain on a traditional commission and research-bundled model.

The new legislation aims to address MiFID I’s shortcomings. The focus of regulation has expanded to include non-equity products, such as OTC derivatives, and will enforce conduct and client suitability rules on intermediaries. MiFID II recognises new types of trading facilities, codifies product governance, and will require unprecedented levels of data recording.

Whether end clients will really benefit is uncertain.

The authors of MiFID I had high hopes too, but that regulation failed to further the integration of European financial markets.

MiFID II may tear up existing business models, but could just shift conflicts from one area to another. Costs may simply move from commissions to wider dealing spreads and issuer payments.

Financial markets compose a complex global system, and remodelling one sector in one region may have unintended consequences. London could lose business to countries with lighter-touch regimes, and the EU as a whole could see activity migrate to New York or Asian centres. Adjusting to this will be a challenge for global investment banks and asset managers.

Certainly, clients deserve control of research costs. MiFID II will shed some light on the workings of the asset management process, but many clients are more interested in outcomes: in returns, control of style, and risk management. Discussing the new system with clients and reporting on research will require additional attention by managers — possibly at the expense of other important issues. Clients are becoming more interested in governance and sustainability, and would rather have data on that. Can the bandwidth in client relationships really be stretched to accommodate all this?

In the EU, the industry does not currently expect that research budgets will fall, but a shift away from the largest investment banks seems likely. Many smaller brokers will fight to keep some sort of relationship with investment firms alive. While this will not be free under MiFID, low charges for research would still offer brokers the opportunity to provide fundraising, institutional access, and IPO services to corporate clients.

The research from these smaller brokers already appears conflicted, often perceived as reflecting obligations to corporate clients. The value to the buy side is less clear, so brokers’ revenue may come from spreads, or possibly as part of fees on corporate transactions. These trades and transactions are infrequent so true cost discovery will be a challenge, if it’s possible at all. MiFID II can control the buy side, but creative new sell-side business models may emerge.

Asset managers might even see some benefit from this forced process and additional cost. Data collection around investment decisions — capturing internal conversations as well as details on trade implementation — will reveal much about how value is created. Managers will be able to monitor research input and leverage the new data into better decisions.

Unfortunately, many of the new services to date, such as research aggregators, present the services as regulatory solutions rather than tools to benefit managers. These providers will need to better align themselves with the business models of buy-side clients.

Regulators cannot encapsulate the business models of all the firms on each side so it will be difficult to tell whether profitability is being recaptured in dealing spreads or corporate transactions. Many of the new specialist research providers that present their work as “independent” research will actually continue to be paid by corporate clients. Most smaller or mid-cap listed companies will likely need to pay for the research provided to investors. In the same way, research from brokers with corporate advisory relationships is already questioned. Will we be any nearer to finding a true market value for this “information”? Will anyone really care if it is buried within the budgets of corporate clients?

The concept of stripping out inducements to establish underlying true execution costs is appealing, but many shares and derivatives will have insufficient liquidity to establish an execution-only price. And the nature of an investing institution’s order flow will be a complicating factor. The system will need some wriggle room if the new regime is not simply to drive a huge incentive for scale on both the buy side and sell side. There could be a further tilt toward passive funds, which essentially benefit from the price formation created by other research. Does this really help market integrity?

MiFID II might herald a new world of alignment and transparency, but the challenge is whether investment banks and brokers providing research will be willing to break out their research bundle. They will aim to preserve broadly based subscription services. Price discovery for this research depends on granularity, but that may require too big a move from the current business model. The value is not primarily in the printed reports. The buy side recognises that analyst calls are expensive but still wants to maintain low-touch access to sell-side analysts.

In theory, the new regime will bring a return on investment into research, but in practice, there will remain workarounds and fudge. Ideally, innovative dynamic pricing models should develop — where the price of research varies as it is disseminated. Major buy-side firms using research will potentially suffer more of a price effect than boutique asset managers, quickly exhausting the value of the insight. A specific research piece or analyst team might capture more value by selling to smaller asset managers to minimise the impact.

Early in 2018, regulators might be tempted to make some high-profile examples in order to highlight best practice. But the industry will be in turmoil for months, and any intervention should be taken with care.

Instead, regulators should be alert to any emerging systemic risks encouraged by the new regime. MiFID II’s problems may surface more quickly than the benefits.

North American and Asian regulators are unlikely to follow the EU until the results become clear.

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