Regulatory Rundown (Part One)
MIFID II: Key Areas to Pay Attention to in 2018
The revised EU Markets in Financial Instruments Directive (“MiFID II” or the “Directive”) came into effect on January 3, 2018. Although the revised regulation is EU specific, its reach is global, sending ripples through the financial services sector as both buy-side and sell-side firms scramble to comply with the stringent rules. We identify a few key areas that we think will be important to keep track of in order to understand the broader ramifications of this key regulation in coming years.
MiFID II, which came into effect earlier this year, replaces the original Directive, MiFID I that has been in effect since 2007, and offers greater protection to investors and enforces transparency across all asset classes: equities, fixed income, exchange-traded and foreign exchange. The objective is far-reaching and aspirational: to restore investor confidence and prevent another 2008 financial crisis from occurring.
Accordingly, MiFID II’s reach is broad and all-encompassing. From commercial banks to brokers, exchanges, fund managers, pension funds and retail investors, all parties need to comply with the Directive. The MiFID II shake-up in the EU requires us to pay attention to certain areas and see how things unfold not only in the EU but also in the U.S. given that a large portion of the financial services sector is affected either directly or indirectly by the Directive.
Here are four key areas that financial services firms globally need to keep an eye on over the next twelve months.
Cost of Research
The most controversial aspect of MiFID II involves how asset managers pay for research that is ultimately used to make investment decisions. Until now, the cost of research has been bundled into trading fees and therefore passed onto investors. Regulators saw this practice as unfair to investors while also potentially creating conflicts of interest where favored brokers are utilized regardless of trade cost.
The European Securities and Markets Authority (ESMA), a member of the European System of Financial Supervision (ESFS), has legislated that asset managers now need to unbundle their trading and research costs into two separate, disparate accounts, providing greater transparency to the investor on the actual execution costs.
Asset managers are now in a precarious position of deciding to either absorb the research costs or pass the costs onto investors. Many are anticipating that due to investor pressure, asset managers will end up absorbing this cost, therefore, cutting their research budgets heavily. Another alternative for asset managers will be creating more research capacity in-house, and we have already started to see some larger firms go down this road. Whatever the outcome, it will be interesting to see how this new rule plays out and whether it will have a broader effect on fund performance.
Sell-side firms will not escape the unbundling rule unscathed. They will be subject to pricing pressure as asset managers will need to demonstrate to their investors that they are executing trades at the lowest possible price. Coupled with this will be increased documenting and reporting requirements that drive both their technology and compliance costs higher.
Impact on Boutique Research Shops
The pricing pressure created by the unbundling rule will directly impact boutique research firms. Whether the impact will be positive or negative is a question that is currently being debated.
On the one hand, asset managers may have little choice but to cut research costs for boutique research providers given both investor pressure and budget constraints imposed by the new unbundling rule. While we have already started to see the impact at large investment banks, the impact on boutique research firms could be more pronounced as firms struggle to compete with their larger counterparts.
On the other hand, there is likely to be a glut of research analysts either laid-off from bulge bracket or mid-tier investment firms or people that have decided to strike out on their own and hang a shingle as an independent research shop. These firms could be a boon to smaller asset managers that still need access to research but cannot afford to procure it from the large banks, and therefore a new cottage industry of boutique research providers may emerge.
Impact on Investors
MiFID II was designed to offer better protection to investors by increasing transparency across all asset classes and aligning their interest with those of asset managers. However, many question whether MiFID II will actually benefit investors in the long run. With good reason.
In order to comply with MiFID II, asset managers will need to implement new technology and comply with additional reporting requirements. The growing costs associated with compliance will tighten already strained budgets, potentially hampering returns in the long-term. Additionally, with fewer providers in the market, access to research will be more limited than before which could also impact returns.
While increased transparency may provide investors with a better understanding of how asset managers make investment decisions, the cost of “pulling back the curtain,” so-to-speak, could potentially end up hurting them long-term.
Impact on U.S. Asset Managers
Given how interwoven financial markets are globally, the majority of asset managers, regardless of where they are located, are expected to be impacted by MiFID II. For example, if an asset manager purchases a listed EU security, it falls within MiFID II’s scope, regardless of where the fund manager is based.
U.S. based asset managers are no exception. Similar to European asset managers, U.S. firms will be impacted by increased compliance and reporting costs. How prepared U.S. managers are to comply with MiFID II and report to European regulators is the question that many will be watching closely in the coming months.
MiFID II is a far-reaching regulation that is sending ripples across the financial services industry. The intended consequences of MiFID II on investors, asset managers, sell-side firms, and research providers is yet to be seen. In addition to watching closely how the key areas addressed above will play out, we will also be tracking how other regulations such as the EU General Data Protection Regulation (GDPR) could add another layer of complexity to an already complex regulatory environment. We will address this in Part II of Regulatory Rundown. Stay tuned.