The MiFID II framework on research cost has set very ambitious targets and requirements to be met by January 2018. If these are met across the spectrum, MiFID II will have successfully increased transparency and substantially reduced conflicts between executions and research within sell side institutions.
The issue however is that while requirements will be met in certain areas, others where it doesn’t make economic sense to implement them may be neglected. This could essentially translate into less market efficiency and transparency for some asset classes.
First, let’s quickly recap on these requirements:
- Sell side firms must not induce clients to trade bundling research within execution services.
- Sell side firms are required to review and identify services provided that could be categorised as research and therefore for which payment would be required.
- Sell side firms need to provide clients unbundled costs of trading, separately identifying and charging execution, research and other advisory services.
- Buy side firms have to make explicit payments for research, and demonstrate that research contributes to better investment decisions and is therefore not inducement.
- Investment firms need to provide better reporting to facilitate payments being made for research and to help demonstrate the value that research is providing.
Implications for organisations involve significant changes within different areas such as compliance, operations and technology; and while large institutions have the capacity and resources to scale up, it may not be the case for smaller players covering niche areas.
Ultimately, the question is down to whether buy side clients will bear the additional costs of research instead of the cost of the significant changes. Large Asset Managers such as JP.Morgan AM and Vanguard have already officially announced they will cover the costs, and Aberdeen Asset Management has budgeted £10 million in anticipation. While these large Asset Managers can cover these costs, it’s the smaller managers with niche strategies, focusing on very specific asset classes may not necessarily have the means to actually fund these research costs.
During the past 10 years, the Asset Management industry has been consolidating, and with the emergence and rapid growth of ETF providers, active managers have been under tremendous pressure to decrease their management fees. Equity for instance is a space where active management has particularly been challenged by ETF, and is also an area where sell side research is widely used. Under MIFID II, whether fund managers choose to directly pay research cost from their own account or use a Research Payment Account (RPA) backed by a Commission Sharing Agreement, new cost will put additional strain on margins and/or slow already sluggish new client inflows.
Smaller fund managers may choose not to pay themselves for research, in particular for small cap stocks. Sell side institutions covering this universe will as a result quit providing research and ultimately, this translates into less information, less investment decision transparency, and more pricing deficiency for small cap stocks.
Let’s reconvene in 2018 and see if MIFID II has successfully increased transparency and substantially reduced conflicts between executions and research within sell side institutions, or not.