As MiFID II enters into force, the dust of the storm revolutionizing investment research it created has not settled yet.
Buy-side companies and research providers have yet to rapidly conclude prices negotiation and contract the resulting substantial costs reductions. Moreover, in order to look beyond MiFID II’s enforcement and the required swift and timely adaptations:
Scene setting – Regulatory reminder
Before diving into the ongoing actions being undertaken for compliance and future ones for the implementation of a more long-term, sustainable strategy, let’s just take a quick step back to set the scene.
MiFID II (the revised Markets in Financial Instruments Directive) is the EU legislation that regulates firms that provide investment services to clients linked to financial instruments, and the venues where those instruments are traded.
This new legislative framework is designed to strengthen investor protection and improve the functioning of financial markets, making them more efficient, resilient and transparent.
Research encompasses material or services (reports, phone calls and meetings with experts, etc.) that provide recommendations, analysis or insights capable of enabling Portfolio Managers, Analysts and Financial Engineers to refine their investment strategies.
Up until MiFID II, research was financed through spreads for FICC (Fixed Income, Currencies and Commodities) and, for Equity, through brokerage fees collected by brokers on every trade executed as a bundle with the execution fees (these research commissions could later be used to pay any research providers via a Commission Sharing Agreement). Therefore, research was paid for indirectly by fund managers’ clients, reducing the overall performance for the client.
MiFID II research requirement
MiFID II aims at increasing costs transparency and preventing conflicts of interests; as regulators feared the research financing practices were conflicted and created unnecessary costs for the end clients, this new regulation revisits them in depth — however, the regulation only focuses on mandates, and leaves out collective and dedicated funds.
Indeed, in a nutshell, MiFID II will require making explicit payments for investment research in order to demonstrate that the research provided is not an inducement.
In more detail, MiFID II requires splitting out the research costs benefiting EU mandates from the execution costs. Research costs can then be either fully financed by the P&L or passed on to clients, which then also require:
- Implementing a separate Research Payment Account (RPA) funded by a specific research charge to the client in the form of research commissions (collected, as they are today, during trade execution), but clearly unbundled from the execution fees.
- Defining a research budget, allocating it to each client and monitoring it.
- Providing clients with:
- information about the budgeted amount for research, and the estimated amount they will be charged for research;
- annual information on the total costs they incurred for third party research;
- on-demand details (a summary of the providers paid from this account, the total amount they were paid over a defined period, the benefits and services received by the investment firm, and how the total amount spent from the account compares to the budget set by the firm for that period).
The only MiFID II requirement regarding funds is that research costs paid by fund clients must not finance research used for mandates management (and vice versa).
At the end of 2017, the market-wide consensus was that virtually no company would be fully ready for MiFID II’s enforcement start date of January 3rd 2018, but rather for fall 2018. As one of the most revolutionary provisions of MiFID II is the requirement to unbundle research and execution, it is no surprise that the implementation phase of the necessary changes for compliance with this research requirement is still ongoing.
Implications for Asset Management companies and ongoing actions for compliance
Many Asset Managers (e.g. Amundi, Axa IM, Vanguard, Northern Trust AM, Pimco, Goldman Sachs AM, BNY Mellon, Generali Investments, Credit Suisse AM and Deutsche AM) chose to absorb research costs on their P&L so as to avoid losing a marketing edge over their competition and having to deal with the operational complexity of implementing processes involving clients in order to comply with the regulation.
Although, some of them (e.g. BNP Paribas AM, JPMorgan AM, Legg Mason, AllianceBernstein, and Candriam), even if they do not always communicate this clearly (using ambiguous language), actually opted for a mixed approach and will only do this for mandates, since the regulation only focuses on them. They will still finance research used for funds with clients’ money through fees collected on each executed transaction, as is done today.
On the other hand, only a small minority of Asset Managers chose to not follow the trend started by the large American firms and to keep passing the costs on to clients for mandates and funds (e.g. Schroders, Janus Henderson, Union Investment, and Deka).
In a general way, this has put the spotlight on a cost that has always weighed on fund performance (the yearly average cost of equity research is usually estimated to be 10 basis points of AUM, and 3.5 bp for FICC) but that most Asset Managers are only starting to pay a close attention to now, as it is going to impact their P&L or be clearly communicated to clients.
Implications for research providers and ongoing actions for compliance
Asset Managers rationing their consumption of research and paying closer attention to the price they are willing to pay for it is expected to have a drastic overall financial impact: for Equities, it is estimated to represent a reduction of around 20% (i.e. $1bn of a $5bn annual revenues business).
Strategic development levers for Asset Management companies
Strategic development levers for research providers
Conclusion: the transformation is far from over
How can Headlink help?
Headlink has acquired a hands-on expertise by leading major industry players in complying with MiFID II, specifically on research, by designing budget and costs management frameworks, and by leading well-advised negotiations and contracting between Investment Management firms and research providers.
Feel free to contact our team if you want to know more about what Headlink can do for you by helping you design and implement short and long-term strategic solutions that go beyond the necessary adaptations for regulatory compliance to develop a decisive edge in this increasingly competitive landscape.