What is MiFID II and why was it enacted?
The Markets in Financial Instruments Directive (MiFID II) was created in Europe as a response to the Great Recession. It is similarly in its broad impact as the Dodd-Frank act in the US. MiFID2 primarily aims to improve transparency in financial markets primarily by ensuring that the execution of trades are performed in the most efficient and cost-effective manner, and making fund companies pay separately for research and trade execution.
The world of finance is basically split into two groups, namely the “buy-side” and “sell-side”. The buy-side constitutes of investment firms that are purchasing assets or securities for their own needs or for their clients (e.g., asset managers, pension funds, insurance companies, private equity, hedge funds). The sell-side sells investment services to the buy-side and generally consists of as the investment banks and brokerages.
One of the most important services that the sell-side provides to the buy-side are the execution of trades for assets that the buy-side wants to purchase/sell. The sell-side provides research insights and analysis such as buy, sell, or hold recommendations of securities to the buy-side. Traditionally, the sell-side does not explicitly charge the buy-side for the research that is provided; however, if the buy-side finds the research and analysis being provided by the sell-side insightful and compelling, they will execute their orders through the sell-side institution. In this manner, the buy-side makes an implicit payment for the research provided by the sell-side via trading commissions.
Typically, the buy-side uses sell-side research in a supplemental manner to further evaluate whether their investment decisions are sound.
MIFID II requires that the buy-side must explicitly pay research services provided by the buyside using a separate account created for this use or regulated commission payments. This regulation was enacted to reduce the opacity in the costs of services that the sell-side provided to the buy-side as there were concerns that the research being produced by the sell-side could potentially be inducing trading from the buy-side, thus having a negative impact on the clients/investors by having to pay additional transaction costs.
For the buy-side, they may choose to charge clients directly for sell-side research employed for their behalf, or absorb these costs by paying for it out of their own P&L. This impacts the sell-side researchers and analysts as it is uncertain how much the buy-side is willing to pay for research services that used to be “free”. the size of the sell-side research industry will shrink as the buy-side may not be willing to pay for these research services and would choose to further develop the research skillsets in-house.
How will MiFID II affect global brokers?
Global brokers are able to absorb the costs of research under the MIFID II regime or slash fees for their research output as they can cross-subsidize these businesses from other areas of the firm. Some global brokers may even distribute their research in the public domain where it becomes a non-monetary benefit so the buy-side firms can receive it for free. However, they are still likely to reduce the size of their sell-side research analyst teams as the prevailing view is that many buy-side firms will choose to further build out their in-house research teams rather than pay for the costs of sell-side research as part of their P&L or charging clients directly for it. Global brokers are likely to only retain their star performers that are consistently ranked within the top five analysts, as buy-side investors would still be willing to pay for their research output. They are likely to cease coverage on small companies or unattractive sectors.
How will MiFID II affect local brokers?
Generally, local brokers with large client-bases in Europe will suffer the largest impact. Local brokers will need to inform their buy-side clients in Europe regarding the allocation of costs for each research activity, and provide details of their order execution policy.
The main concern for these local brokers is that if the global brokers slash fees or absorb costs for their research output, they may not be able to compete on a cost basis. This may lead to a consolidation across local brokers. For local brokers to survive, there will be a need to differentiate their research and ensure that is creates value for the buy-side by giving them profitable, actionable ideas.
For research, local brokers should focus on covering small to mid-cap firms that may be ignored by the large global brokers. Local brokers need to align their research activities to areas where fund managers value the most. Bloomberg surveys show that fund managers value the one-to-one meetings that sell-side analysts have with management executives and the in-depth reports & valuation models performed for specific companies rather than the analyst phone calls, recommendations, forecasts, and reports on a broad range of companies. On the execution side, local brokers can focus on providing liquidity for small and micro cap stocks and illiquid names.
How will smaller listed companies be affected?
Small to mid-cap companies need to recognize that the rationalization in the sell-side research industry will potentially drive up their costs of capital and negatively impact the liquidity and price of their stocks. As the remaining sell-side analysts of large brokers are likely to focus on large cap stocks and ignore the small to mid-cap firms, asset managers are less likely to invest in small to mid-cap companies as they are likely to be more ignorant of the activities of these firms given that there is less coverage.
What can they do to make up for the fact they may not receive analyst coverage now?
Due to pressure from passive fund managers, active fund managers need to control costs and will be less willing to spend on research. Thus, small to mid-cap firms need to recognize this and help to close this gap by investing in activities that ensure that they retain visibility in front of active investors and asset managers as follows:
The following are several strategies they can pursue:
Invest in your investor relations team. Hire sell-side analysts who have strong existing relationships with buy-side firms. Focus on hiring individuals with strong networks with firms that have not traditionally invested in your business (i.e., non-investors).
Go on the road show. Understand the forums and international conferences where asset managers and investment managers attend and ensure that you have a presence to exhibit and present your firms strengths and current activities. Rather than waiting for analysts to come to you, smaller listed businesses will need to actively present and market themselves to investors.
Partner with with brokers. Work with boutique small-cap research houses, and also with larger brokers that provide research to specialized small cap fund managers and larger institutional investors.
Commission independent research. Consider commissioning boutique investment and consulting firms to perform independent research on your firm’s business activities and making this information publicly available. Ensure that the commissioned research is an objective investment theses to avoid any perception of conflicts of interest.