Briefing: MiFID II – The birth of a market
As MiFID II comes into effect, asset managers and brokers must negotiate a price for sell-side investment research
• MiFID II will force asset managers to pay for research.
• Pricing negotiations with brokerage firms have been difficult at times.
• Price discovery for fixed income research is delayed.
• The way research is produced and consumed will change.
Preparations for the European Union’s revised Markets in Financial Instruments Directive (MiFID II) are not going smoothly. The industry is struggling to meet one key requirement – the unbundling of investment research and transaction costs.
MiFID II will end the common industry practice of brokerage firms distributing investment research free of charge in return for execution business, to achieve full cost transparency for end clients.
The rules have potentially far-reaching consequences for asset managers, their clients and their service providers.
A recent McKinsey report estimated that for European asset managers that decide to pay for research in full, profits could be reduced by as much as 15-20%. “The resulting change to research operations will be enormous,” said the report.
Managers have been engaged in a price discovery process and negotiations with brokers ahead of the January 2018 implementation date, but progress has been slow.
A recent survey by the Alternative Investment Management Association (AIMA) showed that six months ahead of the implementation deadline, 34% of alternative asset managers were undecided on how to pay for research.
Traditional asset managers are not faring much better. Many key players have not yet made their strategy clear, including whether they will pass on the cost of research to clients. A spokesperson for Allianz Global Investors says: “As things stand, we are moving along with others in the industry. Sell-side and buy-side firms are engaged in a price discovery process to establish a new market price and value for external research.”
Geoffroy Reiss, COO at AXA Framlington, says: “We are entering into a more detailed discussion and negotiation with brokers which will allow us to agree on a set of prices for the services we get. We will focus on this in the coming months.”
The mood in the industry has been one of frustration at times. The price discovery process needed to establish the value of research has been described as difficult.
Reiss adds: “There has been a significant transformation over the past three years. We have come to a point where we can have a true pricing discussion internally and with brokers, on the basis of what we consume in terms of services.
“The first quarter of this year was a price discovery phase. Brokers established a pricing approach and presented it to us. It was the first time they worked on pricing methodology on these services. It has been a true evolution from three years ago, when you could not talk about price.”
However, there is still some anxiety as to how negotiations will progress further. Jacqui Hughes, senior consultant on regulatory, risk and change management at KPMG, says: “At the moment I don’t think sell-side firms have a good enough understanding of what buy-side firms are going to buy in terms of research. We are in a period of stalemate. The industry has to work hard together to work out what the demand for research will be.”
The unbundling of the market for investment research has potentially disruptive consequences. Gerard Walsh, head of business development at Northern Trust Capital Markets, likens the situation to another familiar case of market disruption. He says: “The best analogy that I can think of is competition between old full service airlines and budget airlines. The latter came to the market offering a product that responded to its needs, and full service airlines had to realise that ultimately the decision about how services are valued rests with the consumer. This is the challenge that the industry is facing now.”
There is wide-ranging speculation about how the industry will meet this many-faceted challenge. In order to price services better, buy-side and sell-side firms could look for pricing models outside their industry. Walsh says: “Fund managers may decide to pay for research in a similar way to how clients reward experts from professional services firms.”
Some firms, most recently Kempen Capital Management (KPM), have announced their decision not to pass research costs on to clients. This implies a renewed focus on internal research capabilities. Lars Dijkstra, KPM’s CIO, says: “Kempen has always invested heavily in both the quality and quantity of our internal research system. This makes us less dependent on external research service providers.”
Other firms, most notably M&G , Woodford Investments and Jupiter have decided to pay for research themselves. Amundi , Janus Henderson, MAN Group and Schroders signalled their intention to pass on the cost to clients.
Meanwhile, there are a few sticking points slowing down negotiations. One is how fixed income research will be valued, because the service is bundled into a spread rather than a commission.
Second, many local regulators are still discussing how to apply MiFID II in their jurisdictions. At one point, there was speculation that the UK’s Financial Conduct Authority (FCA) would take the directive further and ban managers from passing the cost of research to clients.
There is also a lack of clarity on corporate access, the service whereby brokers organise meetings and exchanges between companies and managers to discuss specific issues. If this is considered part of research work, it will have to be priced. But there is a possibility that it will be banned altogether if regulators will classify it as ‘inducement’.
It is clear, however, that asset managers, including those with sizeable internal research functions, will not suddenly stop using external research. However, MiFID II will force asset managers to rethink about how they consume investment research. Dijkstra adds: “We think there is still very valuable research out there that we are prepared to pay for. However, paying for it means you have to focus on quality rather than price.”
Hughes says: “It is really important that investment managers understand what their own research needs are and the value that research is adding. I think that the MiFID II rules and in particular the level of assessment, validation and evidence that the regulator is going to need is going to help managers make smart decisions in terms of what their needs are and how they evolve.”
Undoubtedly, MiFID II will reshape the supply of research. Existing independent research houses offering no execution services are likely to enjoy revenue growth, according to the McKinsey report. Universal banks with small-scale execution operations may see sharp declines in research revenue. Larger brokers and specialist firms offering high-quality, focused research will likely adapt to the market.
Some hope that MiFID II will improve the quality of research and benefit the industry as a whole. Walsh says: “There will undoubtedly be missteps along the way and models that look great on paper but do not survive contacts with the real world. MiFID II will be disruptive, but it will drive quality upwards. Good research ideas, different ways of thinking and especially more connectedness of ideas across sectors will be more highly valued and therefore easier to reward by asset managers and pension funds.”
Hughes concludes: “We will see an evolution in the investment process. It is not just about research. We are seeing a lot of fintech disruption at the moment. I think the landscape of how we buy investment management will change and research is only a part of that evolution.”