As the buyside begins to find solutions to new rules governing the pricing and sale of investment research, independent research providers (IRP) are likely to be the net beneficiaries of the new framework.
The Markets in Financial Instruments Directive (Mifid) II, when effective, will seismically shift the investment research landscape in Europe, currently dominated by investment banks that bundle prices up with execution costs. As of January 3 2018, that would constitute an inducement to trade.
With the buyside now required to review their entire research budgets and sources IRPs, unsaddled by the weight of bank regulation, are already cropping up to fill the void.
“It’s absolutely certain that unbundling will lead to a higher quality, more efficient research market,” said Glenn Bedwin, chief operating officer of Absolute Strategy Research and a board member for Euro IRP, an industry association representing independent providers. “Many people don’t know quite how bizarre the model has been up until now. It was in no way efficient.”
The independent community feels that the new rules will level the playing field, explained Bedwin, as they have always had to be clear on exactly how much each piece of research costs where investment banks have not. Some predictions see potentially thousands of bank analyst redundancies in the years to come.
IRPs have occupied a minor but steadily growing portion of the overall research landscape over recent years: Euro IRP has seen its membership grow from 10 firms in 2004 to 78 today. Many date that growth back to overly favourable research produced by banks on tech companies that led to the late 90s dotcom bubble.
- Unencumbered by bank regulation and perceptions of conflicts of interest, independent research providers will be the net beneficiaries of Mifid II’s new rules surrounding research unbundling;
- The buyside will have to review their entire research budgets, make specific payment accounts and be clear to clients how much they are spending on it;
- Various questions remain unanswered surrounding the implementation including whether or not macroeconomic data is considered research under the framework;
- UK-based IRPs will also benefit from reforms to the IPO process designed to reduce conflicts that arise from connected research.
Despite Chinese walls being established to try to break the link between analysts’ research and their employer’s client list, it’s widely accepted that conflicts will remain.But Sidley Austin partner Leonard Ng is unsure how concerned the majority of buyside firms are about these conflicts.
“IRPs are compelling in that firms can easily demonstrate unbundled research with no conflicts or inducements,” he said. “But if banks are able to produce a model that works for the buyside then I’m not sure the independent providers would be much better off.”
Nevertheless the boutiques, unencumbered by the weight of bank regulation, have emerged. One platform offers an email filter system to prioritise only the most relevant research and, using behavioural algorithms, produces a trail that will show asset managers what pieces they value most. Meanwhile others, like Bloomberg Tradebook, are launching execution-only services – potentially even worse news for investment banks.
It’s possible that asset managers will establish or boost existing internal research teams, but this alone won’t be a solution for the majority, which needs data on different markets, companies and instruments at different times.
UK-based research providers are also likely beneficiaries of proposed reforms to the initial public offering (IPO) process. Working towards the same goal, the Financial Conduct Authority (FCA) wants to reduce conflicts of interest at investment banks by, among other measures, requiring issuers to release their prospectuses before their shares start trading. This will give independent analysts more time to publish unconnected research on the company.
The UK has already made some progress on research payments anyway, in that fund managers are required to value it independently of execution. In early March the regulator criticised the buyside for failing to meet its standards on this.
Bulge bracket squeeze
Mifid II tightens the existing inducement rule in place under Mifid, prohibiting inducements received by managers except for minor non-monetary benefits. It takes the view that research does not constitute an inducement so long as it is paid for out of the investment firm’s own resources, from a separate research payment account, or via a specific pre-agreed research charge to the client.
Many buyside firms will have different pots for bulge bracket firm research and independent providers’ research within their overall research provisions. “So while the overall pot will shrink as a result of Mifid II, we do expect a significant reduction to bulge bracket firms and increased market share being taken by high value research – some from IRPs,” added Bedwin.
"There is a huge amount of research out there that everyone in the industry knows is valueless"
Until now the buyside has had virtually unlimited access to ‘free’ research. That ranges from face-to-face meetings with analysts to notes from the sales desk to high level macroeconomic research available to anyone.
“There is a huge amount out there that everyone in the industry knows is valueless,” said Bedwin. “Good fund managers want to be challenged, even if they disagree with your findings.”
Macro vs micro
Preparing for the new rules is complicated by differing perspectives offered by national competent authorities. The UK’s FCA views macro research as a potential inducement to trade with a bank, if it is substantiated – a term the industry is still trying to understand in its entirety. But France’s Autorité des marchés Financiers takes the view that Mifid II applies to research as it relates to an issuer or instrument – which would exclude macro research.
“How we settle on what is substantive is a really tough decision, and each bank will likely come up with its own view,” said Andrew Bowley, head of regulatory response and market structure strategy at Nomura, at a recent event in London.
“The FCA rather unhelpfully said the buyside should make the determination, so again we have this possibility that our clients are telling us a different view. That is unhelpful.”
The European Securities and Markets Authority is currently updating its Q&A on investor protection with new questions, including whether or not the inducement regime applies to macro, due at the end of March.
“The uncertainty surrounding the final details is one thing keeping me awake at night,” added Mario Muth, head of electronic trading at Deutsche Bank. “There is a concern that we’re making the wrong call on certain pieces because we’re not getting guidance until later.”
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