Impact of MiFID II: Unbundling, the Sell Side and Research Trends (by Ivy Schmerkin)
European regulators are pressing to unbundle research payments from executions. Experts say that a regulatory overhaul driven by MiFID II has the potential to disrupt the global research industry.
Many industry watchers maintain it will put pressure on sell-side firms that support teams of analysts as well as independent research providers. It’s not clear if firms will need to unbundle the menu of research services they provide, including research reports, calls with analysts, corporate access to management teams and conferences.
“The sell side is going to have think about how it produces research and how it’s getting distributed to the client. We will see firms picking the places they want to be in and which sectors they want to cover,” predicted Brad Bailey, director of Celent’s Securities and Investments practice. Clients could see a lot of transitions around the type of companies they cover. “You will see engagement with the buy side on what they are going to do around the research product, and offer clarity around that,” added Bailey. If sell-side analysts were to cut costs and reduce their coverage for small and medium-size enterprises (SMEs), that could impact liquidity, said Bailey.
An Evolution in Process
While unbundling is stirring up uncertainty around the research payment model, the nature of research itself is also evolving.
“The emergence of new research products has been largely data driven,” observed Chris Tiscornia, president and CEO of Westminster Research. “A lot of the new innovation that we’ve seen in the research space over the last 10 years has come from independents, technology companies and from groups that are employing data scientists to scrape data, whether it’s from credit card information, satellite data, or web scraping,” said Tiscornia.
In contrast to the past when analysts covered an industry and wrote up a report sent to all clients, there is more emphasis on the data itself, he said. Asset managers “are taking this data, and interpreting it, making their own assumptions and coming up with their own ideas and create alpha,” he said.
With the research business changing toward a more data-oriented approach, new entrants outside of the banks are driving most of the innovation. One Wall Street firm wrote a note saying there are going to be fewer stock analysts in the future, citing the idea that updating earnings forecasts in models is not enough, as cited in Business Insider. Value-added data and analytics are increasingly being delivered through execution management systems. Research marketplaces are also expected to emerge as another way for institutions to access their existing relationships or explore independent research providers.
The Research Marketplace
“A new mechanism is needed to help the buy side and sell side be compliant with MiFID II,” said Vicky Sanders, co–founder of London’s RSRCHXchange, a new online marketplace that modernizes the way that research is bought and sold. Marketplaces are cropping up in advance of the new rules taking effect on Jan. 3, 2018. As of that date, payment for research can no longer be bundled along with other services and paid for using an execution commission.
“It needs to be funded from somewhere, either from client commissions or from their own P&L,” said a technology source.
If a buy-side portfolio manager accepts free-research from an analyst, this is viewed as an inducement under MiFID II, noted Sanders.
Under the European Commission’s Delegated Directive, the broad definition of research includes “material or services that contain analysis or original insights and reach conclusions based on new or existing information.” The definition also states that the research or service should “inform an investment strategy and be relevant and capable of adding value to the investment firms’ decisions on behalf of clients being charged for that research.”
These services can be paid for through research payment accounts (RPAs) established by the asset managers on behalf of their clients. Or, MiFID II allows investment firms to fund the RPAs by raising their own fees. But it remains to be seen how widespread the RPAs will be, especially since the vast majority of asset managers utilize existing commission-sharing agreements (CSAs).
“Because no one has ever had to pay for research from a bank or broker, an exchange where research is bought and sold is a necessary evolution of the industry,” said Sanders.
Launched in 2015, RSRCHXchange enables buyers of market research to source, brief and commission research from an authenticated pool of global research suppliers. Similar to what Amazon and iTunes have done to improve the consumer experience, research marketplaces are going to emerge to update the investment research workflow.
In addition, MiFID II says that the buy side can’t receive research without paying for it, since that constitutes an inducement. Not only does the buy side have to pay for research, but MiFID requires them “to know the benefit received for those payments,” said Sanders.
On top of that, management needs to have oversight over the process. A buy-side firm needs to know that its portfolio managers and analysts are not accessing research for free, said Sanders. “These things are impossible if the fund managers and analysts are accessing PDFs in their inbox,” she says.
Research marketplaces like RSRCHX remove research from the inbox and put it into the cloud, so it’s accessible from anywhere. That simplifies a fund manager’s life since they can search the full content, access and bookmark reports, and use other interactive options. Then management has oversight through the platform to set budgets, purchase research, and monitor readership so they can see what research their fund managers have consumed.
“The biggest challenge for the banks and brokers isn’t necessarily paying for research. It’s all the oversight that is associated with it,” said Sanders. On the sell side, the biggest challenge for banks and brokers is that research has been a cost center, said Sanders. Under MiFID II, the sell side has to price their research. Instead of being bundled along with other services and allowing an execution commission to cover the cost, research is now going to be a separate line item for buy-side and sell-side firms. “They will have a P&L and they need to develop a business strategy and a price level for their research,” she said.
With business models in flux research analysts are expected to leave the big banks and set up their own shops. “Some of the same voices will be at a different location and they need to distribute their content,” said Sanders.
Now that compliance with MIFID II’s unbundling rules are 14 months away, the pressure is starting to build on all sides.
Firms are also awaiting clarity on whether MiFID II will create an environment in which third parties and independent research providers can continue to be paid through CSAs.
As long as a third party is adding value to the investment process and the client is aware of the cost, it amounts to “substantive research,” which is eligible for payment via CSAs, said a technology source.
Details on Rule Still to Come
Still, the final details are being hammered out. The UK’s Financial Conduct Authority (FCA) released a consultative paper this month taking a stricter stance on unbundling research than what was approved in MiFID II. The UK regulator is requiring managers to operate a single research payment account, which prevents multiple brokers from holding amounts on their balance sheet, reported Markets Media. They also must ensure that money in the RPA is “ring-fenced” from assets of the broker and asset manager.
With upheaval in the air, there is recognition that buy siders will need research payment policies in place by early next year, and that compliance with MiFID II’s unbundling rules will disrupt old models and bring new opportunities to the research business.
There are three key areas where action is required.
Some material changes have come out of ESMA’s review of algorithmic trading.
A consolidated tape will significantly improve transparency and create a level playing field.
AFME said there should be mandatory free data contribution to the consolidated tape.
The review is an opportunity to recalibrate MiFID II regulations post-Brexit.