The Problems with MiFID

Years in planning and one year late, the European Union’s wide-ranging new MiFID II regulation is still going to catch-out much of the industry. Although European, it will impact global asset managers, and may herald change across the industry. No-one yet quite knows how it will work in practice. The aim – to fully and transparently align the industry with the end client – is worthy, but the challenge is in implementation. Some areas remain unclear, including what would represent best practice under the new regime. And, there is a real risk of regulatory arbitrage, with the Directive applied differently in each EU member state. For now at least, the rest of the world will remain on a traditional commissions and research bundled model.

The new legislation aims to address MiFID I shortcomings, by delivering fair, effective and safe operation of financial markets. The focus of regulation will expand to include non-equity products, such as OTC derivatives, and will enforce conduct and client suitability rules on intermediaries. It 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.

MiFID I similarly had high hopes, but failed to demonstrably assist the integration of European financial markets. Its successor looks like it will tear up existing business models, but possibly just shift conflicts from one area to another. Costs may simply move from commissions onto wider dealing spreads and issuer payments. Financial markets are a complex global system, and remodelling one sector in one region may have unintended consequences. London could lose business to countries with a lighter touch regime, and the EU as a whole could see activity migrate to New York or Asian centres. Adjusting to all this will be a challenge for global investment banks and asset managers.

Certainly, clients deserve control of research costs. MiFID will shed some light on the workings of the asset management process, but many clients are more interested in outcomes; in terms of returns, control of style and risk management. Discussing the new system and reporting on research must carve out attention in the relationship that managers have with clients. This may be at the expense of more important issues. Clients are becoming more interested in governance and sustainability, and would rather have extra data on that. Can the bandwidth in client relationships really be stretched to take all this in?

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. While this cannot be free under MiFID, low charges for research would still offer brokers the opportunity to provide fund raising, institutional access and IPO services to corporate clients.

The research from these smaller brokers often already appears conflicted, 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, and so true cost discovery will be a challenge, if 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 detail on trade implementation – will reveal much about how value is created. Managers will be able to monitor research inputs and leverage the new data into better decisions. Unfortunately, to date, many of the new services, such as research aggregators, present the services as regulatory solutions rather than tools that will benefit managers. These providers may need to align themselves better with the business models of buy-side clients.

Regulators cannot get inside the business models of all the firms on each side, and 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 that is provided to investors. In the same way, research from brokers with corporate advisory relationships is already questioned. Will we be any nearer finding a true market value for this “information”, or will anyone really care if its 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 towards 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 represent 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 wants to maintain low touch access to sell side analysts.

In theory, the new regime will bring return on investment into research, but in practice, there will remain work-arounds 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 have much more price impact than boutique asset managers, quickly exhausting the value of the insight. The value of a specific research piece or analyst team, might be better captured by selling to smaller asset managers and minimising impact.

Regulators could be tempted early in 2018 to make some high profile examples to highlight best practice. But the industry will be in turmoil for months and any intervention should be taken with care. Instead, it is more important that regulators should be alert to any emerging systemic risks encouraged by the new regime. MiFID’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.

A version of this article was published as the Op-Ed in Financial News on March 28 2017

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice. A  client fund of my employer owns shares in Alphabet (Google)
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