Changing Landscape of Research under MIFID II

The 2008 global financial crisis gave rise to a new era of financial regulatory reform in its wake. MiFID (Markets in Financial Instruments Directive) II, a framework 7 years in the making, embodies EU’s response to the same. The extensive directive, that came into effect in January 2018, runs up to thousands of pages and covers nearly every asset class (as opposed to its more equity- focused predecessor). It introduces rules pertaining to Investor Protection, Market Transparency and Trade Controlling

Amidst a barrage of regulations, one in particular has captured the attention of many and has been a source of widespread coverage and anxiety, the innocuous sounding “Research Unbundling”. It mandates the unbundling of research services from execution services, i.e. Asset Managers now have to pay separately for research and can no longer club it with the transaction fees being charged to clients. This would help reduce the opacity around research costs borne by clients, giving them a clear picture of what they are paying for. MiFID II gives Asset Managers two options instead: a) Pay out of their own pockets or b) Set up a separate RPA (Research Payment Account) for clients and charge them through it. Most firms have chosen the former. This saves them from the hassle of justifying their research purchases to clients and from the oversight that these accounts would be subject to

The impact is evident: research spending has declined by 20-25% from 2012-15 and, according to Bloomberg estimates, is expected to fall a further 40% by 2020. CFA Institute’s survey assessing the impact of MiFID II a year on illustrates this point further, buy-side research budgets have declined an average of 6.3%, with the decline being greater for larger firms. The impact on research quality though is uncertain. While the CFA survey puts forth a mixed picture, a recent annual survey of 250 Investor Relations Officials performed by Citigate Dewe Rogerson presents a different picture. Among the European companies, (excl. UK) 39% have reported a decline in analyst coverage, while the figure stands at 52% for UK with the impact being more pronounced for small and mid-size coverage. This has had a cascading effect on sell-side firms as well. As a response to the slump in demand, Equity Research headcount at 12 of the largest global Investment Banks has declined 14% from 2013 to 2018.

One could see all of the above as a manifestation of MiFID’s objectives; in essence a trimming of the redundant reports and analyses that had come to characterize the Equity Research industry. However, as with any other regulatory reform, certain unintended consequences have also been thrown up. Take for instance the impact on IRPs (Independent Research Providers). These are smaller firms often set up by ex-IB Equity Research professionals. Before the onset of MiFID II, industry expectations were quite bullish on the fate of these IRPs. A bulk of the research needs of Asset Managers were predicted to have been met by IRPs since IRPs offered distinct advantages over large banks: they were independent, free of conflict, cost less and could provide highly specialized research outputs; characteristics that firms would value in a post-MiFID II world. Bloomberg estimated in 2018 that IRPs’ share of the research market could reach up to 1/5th by 2020. Reality however, tells a different tale. IRP Revenues have by and large remained flat or have even fallen in 2018 (over 2017). EuroIRP, a trade body, puts these figures at 70% and 21% respectively. What is behind the tepid performance of IRPs? Large banks have taken advantage of the fact that, well, they are large. Cross subsidization of research costs through their other divisions has allowed them to lower their prices significantly. This kind of predatory pricing harms IRPs since they are solely dependent on research revenues. While overall headcounts of IRPs in Europe have been up by 13% in 2017-18, this has largely been confined to a few top firms, with most of the smaller IRPs facing growth challenges, thus stalling headcount expansion. IRPs are also burdened with restrictions on providing free trial-period research, making onboarding of new clients tougher.