A point of view from Tim O’Halloran
As implementation of The Markets in Financial Instrument Directive II (MiFID II) draws near, conventional wisdom is that few industry players – both broker-dealers and investment managers – are fully prepared to meet its requirements. In our second of two articles, we look at the more concerning fact that there now seems to be near universal agreement that the regulation will mean there will be less money spent on investment research and less investment research produced—an outcome that is not good for anyone.
During a recent listen to Lynyrd Skynyrd’s Street Survivors, the song That Smell somehow led us to think about the conundrum of MiFID II. As fans of Lynyrd Skynyrd know, the song’s lesson is that a bad recipe will usually yield bad results. But this time it left us wondering: “Can a good recipe also yield bad results?”
Surely, no one can argue with the goals that MiFID II is designed to accomplish: greater transparency and enhanced consumer safeguards while promoting best execution and increased competition. This is a great recipe, indeed, so what could possibly go wrong?
There are a lot of moving parts to MiFID II. It is a broad and far-reaching regulation and one of the most meaningful in Europe for many years. MiFID’s scope may be part of the problem. While regulators started out with a simple plan to update European financial industry regulation, the result has been an encyclopedia of new requirements and an industry-wide conversation as to who should foot the cost of research – investment managers or their asset owners. The net result will likely undermine the availability of research and insights for everyone.
While a handful of industry studies present different estimates about how deep the cuts to research may be, none of them are particularly promising. In fact, they all pose the same question: “Is damaging a vibrant research marketplace an acceptable side-effect of MiFID II regulation?” Some argue that this will cull the marketplace of marginal research and that while it may be a painful transition, the newfound transparency will be worth the short-term pain.
At Tourmaline, we’re not so sure. The availability of research in the marketplace is certainly better off being driven by market forces than regulation. And good regulation isn’t typically followed by a painful transition. While this may be more erosion than an earthquake, industry-wide concerns about unintended consequences seem well founded.
A New Challenge for Investment Research
Three years ago, we published an article entitled The End of Research in Europe arguing that an all-cash marketplace for research, then contemplated by regulators in the UK and Europe, could very easily decimate the production of investment research. It’s somewhat ironic that regulators have instead worked hard to avoid this by allowing the use of commissions to acquire research, but have made the requirements so costly and so cumbersome, that the result may be the opposite of what they intended.
The challenge lies in MiFID II requirements that Research Payment Accounts (RPAs) replace the simpler and widely accepted Commission Sharing Arrangements (CSAs). MiFID II and RPAs will be implemented on January 3, 2018, yet there are still differing views as to the structure and the flow of funds through RPAs, likely to vary by broker, which has led many to question what will be considered best practice. Many brokers question if they even want, or need, to participate in this new construct.
Meanwhile, the expected costs of implementing a compliant RPA structure have led many investment managers to seek alternative solutions for funding research. Sadly, many in the industry have referred to the RPA construct as a Rube Goldberg scheme. None the less, MiFID II will soon be implemented in Europe, amid many concerns and a few eleventh-hour tweaks.
While it would certainly make sense for other country regulators to watch and wait, the Securities and Exchange Commission (SEC) had no choice but to address a few immediate concerns. With the new MiFID rules, U.S. broker-dealers could no longer provide research to MiFID regulated managers without breaching U.S. regulations, so in October, the SEC provided no-action relief to address these concerns, granting:
The ability for US broker-dealers to legally receive cash payments from MiFID-regulated managers, though only temporarily as this was set as a thirty-month relief.
The ability for investment advisors to aggregate client orders (trades), even when some of the clients might have different (or no) research credit applied.
The ability for US managers to fund RPAs, but only with commissions and only if they adhere to Section 28(e) requirements.
Even with this relief, there is still concern on the part of regulators and market participants that these European rules may damage the production of research, particularly research on small and mid-cap companies, that could compromise the IPO market and harm the ability for small, emerging companies to grow. As the number of public companies in the U.S has been declining since the 1990s, less investment research would only exacerbate a trend that does not help the investing public.
Other concerns continue to weigh on both brokers and investors. The costs of staying compliant – in the form of operations, compliance, technology and reporting upgrades are meaningful. This provides a distinct advantage to larger players on both the buy- and sell-side who can better afford to address these issues, in turn reducing competition in the marketplace. There are also still concerns about regulatory arbitrage – the disincentive for managers to establish businesses in countries where regulatory costs are steep, as well as the possibility that larger players will shift research funding to the U.S. and Asia.
What We’re Seeing
As we approach implementation of MiFID II, we have already seen at least one major U.S. broker-dealer start the process of becoming an RIA (Registered Investment Advisor) to plan for the future. Time will tell if others follow.
This month we heard a rumor that at least one bulge bracket bank in the U.K. was reviewing its policies to ensure that traders would not write or say anything that could be deemed “substantive” and therefore run afoul of the new MiFID rules. The concern of this firm was that traders and research salespeople might add value that is unaccounted for, and thus, possibly an inducement. So instead of brokers calling investment managers with good ideas, the regulation has created an incentive to disengage. Again, this comes next to the news that there will already be less research available to the buy-side.
We also note that firms that provide research tracking and reporting solutions to support the new MiFID II requirements, while once a cottage industry, are now growing. This includes companies producing tools and applications which measure the amount of research that a manager uses, track specific research interactions, handle broker voting, help to produce research valuation models, etc. These tools will be another incremental cost to investment managers. In the name of transparency and cost management, all of this is good. Yet we can’t help but think that most buy-side CFOs are wondering why they need to spend more money to track less research. Perhaps monies spent on these new regulatory requirements could be put to a more productive use.
Tourmaline regularly fields questions about what MiFID II means for U.S. investment managers. While we now have more clarity from the SEC on what it means to be MiFID-friendly, the focus has turned to research. Managers are concerned about the available supply of research and the future of research production, as well as the issue of full price transparency for all research, globally. Investment managers in the U.S. are well aware of the price discovery taking place for sell-side investment research in the U.K. and will factor this into their 2018 budget forecasts in the U.S.
Does performance now take a back seat?
With regulators and asset owners apparently focused on how much active managers spend on research, we are forced to wonder if this is missing the forest for the trees.
Is it better that managers use less research? Is it possible that a manager’s research spend will soon be the new metric that dictates if they are hired or fired? Does performance now take a back seat? It’s hard to envision a marketplace where outperforming investment managers are fired for spending too much on research.
Transparency has changed many industries for the better. It typically opens the door to a better understanding of a business and its true costs. It can help drive profitability and remove fat from the system. With MiFID II, transparency has launched an industry-wide debate on P&L pricing and the question of who should bear the cost of research, an investment manager or the asset owner.
When providing research, investment banks do not operate like retail stores. At Macys, or Marks & Spencer, both millionaires and starving musicians pay exactly the same price for the same product. Our industry is different – broker-dealers providing research and investment managers who use research, all benefit from a natural subsidy that is created by virtue of the fact that commissions serve as the currency of exchange to acquire research.
Large investment managers typically generate more in commissions than their smaller counterparts. Brokerage firms collect commissions from firms of all sizes, and provide execution, research and other services in return. Larger investment managers use more of the resources, and smaller managers use less, but this structure benefits ALL asset owners.
The aggregate commission pool allows for brokers and independent boutiques to produce a wealth of research that benefits everyone. The nature of this subsidy has created an equilibrium that fosters competition among investment managers and brokers of all sizes, while creating a marketplace in which research has flourished. It is also important to note that the industry’s fee structure, consisting of brokerage rates and management fees, are predicated on the fact that the cost of research is embedded in trading commissions.
If we remove this subsidy, it may mean that less research is actually produced. This is the cause for concern: right recipe, wrong result. And it begs the question “What other unintended consequences come next?” This explains why the SEC has issued temporary relief and has chosen to move cautiously.
…if we want to have active management, we need to support an industry framework that allows for investment research to flourish.
The financial services industry in the U.S. and abroad will continue to debate the topic of who should bear the cost of investment research and it’s not the first time this topic has been raised.
While some asset owners may be pleased to unburden themselves from the cost of research, and will speak up about it, we expect that others may not. At some point, a large plan sponsor will point out that there are plenty of passive options for asset owners who don’t want to foot the cost of research, AND, that if we want to have active management, we need to support an industry framework that allows for investment research to flourish—as already exists now in the U.S.
Given the recent temporary no-action relief, we do not anticipate any policy change that would preclude U.S. investment managers from using commissions to acquire research. Certainly, small and emerging investment managers, many of whom do not have the luxury of funding research via their P&L, will continue to use commissions. This will happen via Client Commission Arrangements (CCAs) in the U.S.
Generally, the SEC’s no-action relief is viewed as a net positive for the use of CCAs/CSAs in the U.S. Some larger managers may choose to pay cash, but they will be the exception to the rule, at least in the short term. Most will wait to see which way the wind blows. Broker-dealers, both in the U.S. and Europe will continue to tighten their belts, focusing on core competencies to ride out the storm. (See our thoughts on unbundling and specialization earlier this year.) Lastly, we also expect that asset managers of all shapes and sizes will take a renewed look at the economics of their businesses.
With all of this, the coming year will be interesting. As the dust begins to settle in 2018, we hope that greater transparency and other perceived benefits derived from MiFID II regulation will not come at too great a cost.
To learn more about Tourmaline Partners, or to hear our thoughts on how MiFID II will impact the industry, please give us a call.