For those working in European financial services the MiFID
II (Markets in Financial Instruments Directive) legislation, which came into
effect on 3 January, potentially marks one of the biggest shifts in the
business since Big Bang in 1986. The latter marked the liberalisation of
financial services by deregulating many of the practices which had previously
characterised the City of London (notably the abolition of fixed commission
charges and the demarcation between market makers and the brokers selling
stocks). For a time in the late-1980s, the City felt a bit like the wild west
as companies with deep pockets rushed to expand into new business areas against
a backdrop of relatively lax regulation. More than three decades later, if
MiFID does not represent a 180 degree turn it is certainly a long way around
the dial.
The objective of MiFID II is to strengthen the degree of investor protection by improving the functioning of financial markets. This in turn implies increasing the degree of market transparency and resilience. The law puts a much greater onus on counterparties to accurately report trades and the prices at which they take place (the transparency part). Enhanced reporting structures are also required to ensure that the products which are sold by financial institutions are appropriate for the client, thus reducing the likelihood of a bust (the resiliency aspect). It is thus far harder these days to flog inappropriate products to unsuspecting clients in order to make a fast buck. About time, of course. We have heard too many stories of misselling over recent decades to avoid the conclusion that some parts of the industry cannot be trusted to regulate themselves and that they will have to be forced into it by the power of the law.
The scope of the products to which all these regulations apply is also being expanded as MiFIR (Markets in Financial Instruments Regulation) comes into force. Not surprisingly, the costs of implementing the procedures required to comply with the new regulations are enormous. And nobody knows how the regime will work in practice. The whole process is based upon the application of “best execution” – the duty to get the best price in the shortest possible time. But this is open to a great deal of interpretation. There is also a risk of regulatory arbitrage across the EU if the MiFID II rules are implemented differently across legislative regimes. Moreover, whilst it is impossible for business conducted in the EU on behalf of EU-based clients to avoid the scope of the law, there is no reason why business conducted in the EU on behalf of extra-EU clients need be subject to the same rules. Accordingly, this could drive some activity out of the EU towards more light-touch regulatory areas.
From a research perspective, the biggest issue is that the costs of research now have to be unbundled and can no longer be hidden within trading commissions. The law now says that financial institutions managing money on behalf of clients are no longer allowed to receive unsolicited research from those providing investment advice. Thus, asset managers now have to enter into a contract with a sell-side institution to ensure that they are compliant with the law, in order that those whose funds they are managing can see how much they are being charged for research advice. We have known for some time that this issue would hit us eventually and many firms have been thinking about its implications for at least two years. What is particularly interesting is the process of price discovery that has since taken place.
Initially, firms providing financial research aimed high but as asset managers baulked at the charges, so they have been dramatically reduced. Much of the anecdotal evidence suggests that research costs will not be covered by the fees paid by the buy side which is going to change the face of financial sector research. An article in the FT last week asked us to “spare a thought, friends, for Julian Bonusworthy. North of 40, he works for a respectable if second-tier global bank with towering offices in London. He is an equity analyst, advising fund manager clients what to buy and sell. His base salary is £350,000 and in a good year he takes a big performance award at year-end. His twins are in private school, the Land Rover is paid for and his £4m house is not.” He may be an imaginary character but research analysts earning that kind of money are about to become a much rarer breed[1].
The largest company by market cap in the FTSE100 is HSBC. According to Bloomberg, it is covered by 33 analysts of which 12 have a buy recommendation; 5 a sell and 16 a hold. One thing is for sure: the buy side of the industry simply does not have the budget to pay 33 analysts to cover this single stock, and they certainly do not need to shell out huge amounts to be told to hold. Therefore a lot of winnowing is about to take place. Firms which can offer a wide range of client services will continue to find a market for single stock research and offer it at competitive prices. Those continuing to offer good investment ideas should also be able to continue making a living. But for many people in financial services life is about to get a lot harder. Big Bang may have heralded the start of the financial research industry; MiFID II might sound its death knell.
The objective of MiFID II is to strengthen the degree of investor protection by improving the functioning of financial markets. This in turn implies increasing the degree of market transparency and resilience. The law puts a much greater onus on counterparties to accurately report trades and the prices at which they take place (the transparency part). Enhanced reporting structures are also required to ensure that the products which are sold by financial institutions are appropriate for the client, thus reducing the likelihood of a bust (the resiliency aspect). It is thus far harder these days to flog inappropriate products to unsuspecting clients in order to make a fast buck. About time, of course. We have heard too many stories of misselling over recent decades to avoid the conclusion that some parts of the industry cannot be trusted to regulate themselves and that they will have to be forced into it by the power of the law.
The scope of the products to which all these regulations apply is also being expanded as MiFIR (Markets in Financial Instruments Regulation) comes into force. Not surprisingly, the costs of implementing the procedures required to comply with the new regulations are enormous. And nobody knows how the regime will work in practice. The whole process is based upon the application of “best execution” – the duty to get the best price in the shortest possible time. But this is open to a great deal of interpretation. There is also a risk of regulatory arbitrage across the EU if the MiFID II rules are implemented differently across legislative regimes. Moreover, whilst it is impossible for business conducted in the EU on behalf of EU-based clients to avoid the scope of the law, there is no reason why business conducted in the EU on behalf of extra-EU clients need be subject to the same rules. Accordingly, this could drive some activity out of the EU towards more light-touch regulatory areas.
From a research perspective, the biggest issue is that the costs of research now have to be unbundled and can no longer be hidden within trading commissions. The law now says that financial institutions managing money on behalf of clients are no longer allowed to receive unsolicited research from those providing investment advice. Thus, asset managers now have to enter into a contract with a sell-side institution to ensure that they are compliant with the law, in order that those whose funds they are managing can see how much they are being charged for research advice. We have known for some time that this issue would hit us eventually and many firms have been thinking about its implications for at least two years. What is particularly interesting is the process of price discovery that has since taken place.
Initially, firms providing financial research aimed high but as asset managers baulked at the charges, so they have been dramatically reduced. Much of the anecdotal evidence suggests that research costs will not be covered by the fees paid by the buy side which is going to change the face of financial sector research. An article in the FT last week asked us to “spare a thought, friends, for Julian Bonusworthy. North of 40, he works for a respectable if second-tier global bank with towering offices in London. He is an equity analyst, advising fund manager clients what to buy and sell. His base salary is £350,000 and in a good year he takes a big performance award at year-end. His twins are in private school, the Land Rover is paid for and his £4m house is not.” He may be an imaginary character but research analysts earning that kind of money are about to become a much rarer breed[1].
The largest company by market cap in the FTSE100 is HSBC. According to Bloomberg, it is covered by 33 analysts of which 12 have a buy recommendation; 5 a sell and 16 a hold. One thing is for sure: the buy side of the industry simply does not have the budget to pay 33 analysts to cover this single stock, and they certainly do not need to shell out huge amounts to be told to hold. Therefore a lot of winnowing is about to take place. Firms which can offer a wide range of client services will continue to find a market for single stock research and offer it at competitive prices. Those continuing to offer good investment ideas should also be able to continue making a living. But for many people in financial services life is about to get a lot harder. Big Bang may have heralded the start of the financial research industry; MiFID II might sound its death knell.
[1] As
for economists who, I can assure you, earn much less the MiFID legislation defines investment research as “financial
analysis or other forms of general recommendation relating to transactions in
financial instruments.” Technically, that means we are largely exempt since
much of our analysis does not relate to transactions in financial instruments.
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