The future of investment research post-MiFID II

This analysis is by Bloomberg Intelligence analysts Sarah Jane Mahmud, Alison Williams and Ben Elliott. It appeared first on the Bloomberg Terminal. 

MiFID is disrupting the investment-research world
MiFID II will require investment research to be paid for in one of two ways: from a fund manager’s own account, which may be recoverable by raising fees, or via a ring-fenced client research-payment account. While regulators will permit research charges to be collected alongside transaction commissions, subject to strict conditions, there should be no link to transaction value or volume. The move to an unbundled model will limit the long-held use of commissions and is being disruptive to the industry globally.

Unbundled pricing models will change research market forever
Banks are adjusting their pricing models for investment research in preparation for EU reforms that will prevent research from being paid for directly using dealing commissions. In an unbundled world, based on execution-only commission rates where payments for research are separated, competition in equity research, as well as fixed-income, currency and commodities research, is likely to rise. Managers may look beyond traditional sources, triggering fragmentation. They may also move research in-house.

MiFID II seeks to swap commission-sharing for payment accounts
Under MiFID II, asset managers will only be able to pay for research directly or via a dedicated ring-fenced client research payment account. The research charge may be collected alongside transaction commissions, but the strict conditions attached to the payment-account model render the current simple commission-sharing regime infeasible — a modified commission-sharing model will be needed. There will probably be growth in use of commission-sharing models in continental Europe as take-up has been limited.

Research revamp gains steam, MiFID II payment-model plan matures
Asset managers that pay for research via a dedicated client research payment account will need to follow strict budgetary and disclosure rules. Yet, they’re likely to welcome news from ESMA that money held in such an account would legally belong to them. This means that, in the U.K., client asset rules (CASS) shouldn’t apply. In a retreat from prior proposals, short-term commentary with no substantive analysis may be provided with no charge, so not all sales and trading calls will be chargeable.

MiFID II research-payment option yields challenges for managers
While the CSA/RPA model may be the predominant research-funding choice post MiFID II, it will likely pose many challenges for managers with limited CSAs already in place, as is the case in continental Europe. They will need to consider how many of the current brokers would be required to execute the percentage of CSA trades needed to fund research budgets. As each broker would be providing monthly CSA balance statements, potentially covering hundreds of thousands of trades, data issues aren’t insignificant.

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Managers awash with MiFID II tsunami of research record-keeping
Asset managers will need to adhere to a slew of new, granular record-keeping requirements if they opt to pay for research via a special payment account. Failure may expose them to hefty financial penalties. The EU rule mandates managers must track and evaluate all substantive research services — including those beyond the written word — and demonstrate how they can contribute to better investment decisions. They will also need mechanisms to manage and track the blocking of unsolicited research.

Research quality under microscope as MiFID II unbundling nears
The price and underlying value of investment research is subject to increasingly close scrutiny as MiFID II inches forward. This is regardless of whether asset managers choose to pay for research via a dedicated client research payment account — a more sophisticated form of commission-sharing agreement — or from their own P&L. Asset managers will likely become a lot more selective about what they buy, opting for tailored coverage from a select number of bank and independent research providers.

Most brokers are likely to opt for tiered pricing, with different levels of access to research at varying prices. Another option is research a la carte, with set pricing for individual research products by analyst or industry, but the same product can have a different value to different managers.

Research-commission restraints could cut bank research spending
EU plans to separate research from execution spending could cause banks to streamline their research offerings. Larger banks, which can cross-subsidize research and offer a wider range of ancillary services, may thrive in a more competitive market, along with established smaller providers. Those in the middle could be more at risk, though they may see an opportunity in providing research on small- or mid-sized companies that are generally likely to receive less attention from larger competitors.

Portfolio manager research spending may feel MiFID II squeeze
Asset managers in the EU will have to pay for research directly or via a research payment account from Jan. 3, 2018. While commissions might be used to fund such an account, strict rules governing use may make them costly and unattractive. Discrete costs for research may pressure margins, likely increasing operating costs, which could make active managers less competitive than passive managers. Asset managers, particularly smaller ones, may struggle either way, leading to less spending on research.

As MiFID II day nears, credit research clarity expected in 3Q
As MiFID II’s go-live date of Jan. 3 nears, after over six years in the making, EU investment firms should gain more clarity in 3Q on how the research unbundling rule will work in practice. ESMA is expected to publish further Q&As to give companies more practical assistance, particularly in credit markets. Meanwhile, U.S. brokers remain in discussions with the SEC to resolve the clash between MiFID II and U.S. law that currently restricts them from accepting research payments by EU firms.

In 2H, sell-side firms will be finalizing pricing models, while buyside firms must decide how to pay for research and whether they’ll apply the MiFID II standard globally. The U.K. FCA, which published its final policy changes on July 3, will amend any of its rules should new ESMA guidance conflict.

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