While unbundling of research and execution has gotten a lot of attention in the wake of MiFID II, the regulation isn’t the only driver shaking up the investment research sector. But research will be consumed in a completely different manner, and competition among providers will increase as asset managers become more selective about what they buy.
There is a lot of talk around the unbundling of research and execution in the wake of MiFID II, but it is far from being a new topic on the regulatory agenda. Nor is it the sole driver shaking up the fairly static and predictable investment research sector.
In MiFID terms, the UK Myners report in 2001 started the ball rolling and there have been many false starts since. The European regulation, which is set for January 2018, is a firmly ensconced topic, forcing brokers and asset managers to review their payments structures and strategies.
There are other reasons behind the restructuring of the provision of research. Banks, which are under regulatory pressure, are closing their research departments, as they search for more profitable cost centers, while analysts are looking for different and flexible opportunities. Moreover, asset managers are becoming more demanding as the prolonged interest rate environment is pushing them to look for innovative ideas to generate alpha.
The MiFID II Dilemma
Shifting from a predominantly commission sharing agreement (CSA) managed research and execution program to full unbundling and integration of the proposed Research Payment Account (RPA) will not be an easy task. In fact, a recent study by TABB Group – “Unbundling: Opening Pandora’s Box” – showed that only 10% of European buy-side participants see themselves as fully unbundled compared to around 23% in the UK.
One of the main reasons is that few participants expected that the CSAs, which are the preferred payment option, would no longer be the main currency for payment. These agreements allow the buy-side to accrue their commissions with brokers, and separate the execution from the research component.
Under the new rules, CSAs will still have a purpose, but they will need to be supported with an RPA, which separates accounts funded by client money allocated specifically for the purpose of research payments. The RPAs would require asset managers to set a monetary budget for research that would not be tied to transaction volume. Fund managers and hedge funds that can use client money to pay for research would go down this route, while firms that cannot use client money must pay for research directly or fund the RPA themselves. However, there is industry confusion over whether CSAs can co-exist with RPAs.
For example, in its consultation paper, the French regulator advocated the CSA model, provided there are additional checks and controls in place for monitoring and measuring. By contrast, the UK Financial Conduct Authority prefers managers to have a single RPA which prevents multiple brokers from holding amounts on their balance sheet. It stated that operationally, this will require changes to current CSA accounts.
The challenge becomes even more complicated because MiFID II not only pertains to equities but across the spectrum. This means that brokers will have to provide accurate research pricing by specific asset class.
Not surprisingly, as the TABB Group report notes, these impending changes have made the sell-side rethink its research value proposition, as the buy-side will have greater accountability for which firm it chooses for such services. “If the buy-side decreases its external research spend, internal resourcing may increase but ultimately leads to a decline in sell-side investment in research provision, which in turn leads to a further fall in revenue opportunity for the banks,” according to the study.
And, although the MiFID rules are confined to Europe, global firms may not have a choice but to implement them, according to analysis by Bloomberg. It showed that the operational burden of running two different research structures might be too costly, forcing them to look toward a MiFID II-style research approach, which in turn could encourage regulators outside of the region to adopt similar regulations.
Changes Already Afoot
These changes have been coming for a long time. Many brokers have already taken action, with some, such as Nomura, closing their research departments, while others have downsized or, in investment banking terminology, “juniorized” their research and distribution teams. There has also been a tendency to tier clients in platinum, gold and silver buckets, depending on their overall spend, which has left some disadvantaged.
Another main concern among the buy-side community has been that the depth and breadth of coverage has been compromised, with the output focused on the more profitable large cap sector to the detriment of their smaller and medium-sized brethren. The same fears apply to less fashionable stocks or sectors, which will suffer if they come back into vogue at a different point in the cycle. There may not be anyone left to cover them.
The larger fund management groups have also already been building their internal resources to rectify some of these issues. In some cases, this has led to a drain of talent from their sell-side counterparts.
Looking Ahead
Against this background, it is difficult to predict just how much the new research landscape will change in the next few years, but there is no doubt that there will continue to be different configurations on the market. Competition will increase as asset managers become more selective about what they buy.
The same trends can be seen in music, where streaming has fundamentally altered the industry’s business model. In the same vein, research will be consumed in a completely different manner. There will be a greater number of independent firms that provide tailored or niche reports, as well as research platforms that amalgamate offerings from different analysts or providers with a varying range of payment options. This could cover purchasing a subscription or buying reports with cash as well as using CSA or the new RPA, depending on the fund manager’s own requirements. Whatever the end result, these are positive steps toward an investment research industry that is less fragmented and better able to serve the market.
As featured in Tabb Forum
