MiFID II Research Unbundling: a few miles down the road

Steven van der Zeeuw

In almost every asset class investment research plays an important role as a source of intelligence and guidance for investing. Recently, new European regulations in the form of MiFID II have changed a lot in this field.

MIFID II was implemented on January 3rd 2018 and with local regulatory authorities starting to monitor market participants, there is a growing concern with regard to feasibility of compliance with MiFID II. Smaller asset and wealth managers are of particular concern, as the larger players are better able to handle the considerable investment needed to comply.

Nonetheless, large asset managers do have substantial challenges in this area. The rules surrounding research unbundling are of specific concern. Previously, under the so-called Commission Sharing Agreements (CSA’s), asset managers could pay for investment research as part of the commissions they paid for trading. Under the new EU regulation these “soft dollar” agreements are a prohibited inducement. EU asset managers are now obligated to pay for the research through their own P&L or to pass the cost on to their clients through specific client Research Payment Accounts (RPA’s). The latter option comes with a whole array of additional (somewhat subjective) requirements, which is why most Dutch asset managers have chosen to pay for investment research through their own P&L. Interestingly, we see that asset managers passing research costs on to clients (through RPA’s) endure between 2.7 and 7.5 times higher cost for research (Frost consulting, Sept 2018). This of course raises all sorts of thought-provoking questions.

Asset managers have expressed their challenges on this aspect of MiFID II

Firstly, there is a lack of clarity on the pricing of research. What is a reasonable price for each type of research? How will pricing evolve, and what is the impact of the price paid for research on compliance with MiFID II? There is also the point of view of the regulatory authorities (AFM, FCA). How, when and to what extent will monitoring take place? Another challenge is the definition of research. What is research under the new rules? Other points of concern are how to handle unsolicited research and how to monitor the quality of the research received in a market which is constantly evolving.

The market for research is on the move

As a result of the new regulation, the market for investment research appears to be in flux. Large global brokers producing research are lowering their prices drastically (in some instances down to only a few thousand euro’s for an unlimited subscription to written equity research). They are willing and able to do so, since research is not their core business. They prefer to earn their money through brokerage commissions and investment research is only seen as a support function for that (as can also be seen in the old set-up of the CSA’s). At the same time, pure play research providers and local/niche players have not reduced their prices (as much). So, the question is what will happen to the parties that have research as their core business. Buy-side consensus appears to be that there will always be room for the large global (pure play) research providers but rough times are expected for the local niche players, as a consolidation wave is expected to take place.

Asset managers are reviewing their research intake, pricing is the main point of concern

Most asset managers have reviewed, or are in the process of reviewing, their research intake. This is to rationalise the portfolio of research providers and (re)negotiate contracts, thus reducing research expenses. The key challenge in the contract negotiations is access and distribution of research within the organisation. In these reviews and price negotiations all asset managers have seen prices drop, especially from research provided by large brokers.

We asked a group of leading asset managers to give a price range of what they thought was a reasonable price to pay for equity research. To make things comparable we asked to consider unlimited access to written equity research from a global Tier 1 research provider. The results were quite dispersed, ranging from €5,000 to €200,000. Even with the number of users of the research having some effect on price, the differences are staggering and suggest there should be room left for price efficiencies.

Portfolio managers can however be hesitant towards intense price negotiations with research providers, as they fear that the procurement department takes total control of the process, making price more important than quality in the selection process. Alpha’s view however, is that the best result, both from a quality and from a cost perspective, is reached by keeping the front office in the lead while using the expertise from procurement to get the best price. First step is to have all research consumers decide on which research providers are needed. This list is then handed over to procurement to negotiate the best price. The front office should be leading while taking advantage of the expertise of procurement.

After the rationalisation, the list of research providers has become smaller and the related cost has come down (and if it is done right, the quality has not come down). Various market participants have floated the idea to then return part of these savings to the portfolio managers as spare budget to spend to their liking on research, besides the standard research subscriptions. For instance, costs related to meeting certain analysts. By doing so, portfolio managers can get more bang for their buck.

(Too) low prices for research

The remarkably low prices currently asked for research by large Tier 1 global brokers are of some concern to asset managers as they wonder at what price point buying research begins to count as an (non-permitted) inducement. If prices paid for research come down to almost zero, the regulation does not result in the desired effect. It would be interesting to investigate whether regulation has changed the choice of execution broker by asset managers to see if the regulation has had its effect. Looking at the regulator for this specific issue is of no effect: the AFM does not provide guidance on this matter and asset managers are left wandering in the fog.

Unsolicited research: what has been read cannot be unread

An additional issue for asset managers is whether research providers are sending their portfolio managers the research on an unsolicited basis. This could be seen as an inducement, as no payment is taking place for the research. Asset managers are in the dark on how to ensure compliance on this topic and currently instruct their portfolio managers to send out a standard reply. The question is whether this is enough from a compliance point of view.

The definition of research

Among asset managers there is a lot of ambiguity concerning the definition of research. The question asked is when does research actually count as research under the new rules? So, for example, if a portfolio manager receives an email with a macro view, does this count as research? And what about a casual chat with an investment analyst? Or fund brochures sent to asset managers? These questions need clarification and most asset managers would prefer the clarification of the definition of research happening on a European level instead of by the local regulator.

Value of FinTech and RegTech is limited to compliance for asset managers

There are plenty of FinTechs and RegTechs with solutions to help asset managers in their challenges with regard to investment research in general, and for research unbundling more specifically. There are roughly two types of solutions offered. The first solution is a platform model which can be viewed as an ‘app store’ for research. The second solution is a software model, which can be seen as an intelligent anti-virus software covering all research consumption in the organisation through AI and integration with company applications.

Cooperation with FinTechs is no novelty for the buy-side. Most firms have been in touch with Fin/RegTechs on this subject. The added value on this subject is however seen as limited to the RPA model (where the client pays for the research), when generating a clear audit trail is more relevant. Overall asset managers do not see research Fin/RegTechs as being capable of improving the investment decision. Fin/RegTechs are considered to be of added value in the compliance sphere.

Going forward

To begin with, it will be interesting to see the results of the FCA review, which will soon be published as announced in June 2018. The FCA were concerned that the rules were not being interpreted correctly. Similarly, there is a question around how the AFM will proceed on this topic, and to what extent the AFM will be conducting their monitoring role over research unbundling?

Another question is that of evolving regulation, which always takes several years to come into effect (MiFID II discussions started in 2010 and implementation was in 2018). Yet, regulation always evolves. After seeing the first cracks in the current framework already with the ongoing FCA probe and the (unsustainably) low prices for research, things could move quicker than expected. Be it MiFID III, be it local regulators upping the ante.

In addition, Alpha will continue to monitor developments in the wealth management industry surrounding research unbundling. The dynamics described in this article appear to be similar for the wealth management industry, be it quite often on a smaller scale then asset managers.

Finally, how will the market for investment research evolve in the future? Will the expected consolidation wave among local/niche research providers take place? In any event, it will be interesting to follow the next round of reviews asset managers are doing of research providers, and whether we will be seeing a further reduction of prices and a further rationalisation of research providers.

About the Author

Steven van der Zeeuw

Steven is a consultant working for Alpha FMC from the Amsterdam office. From his previous role as portfolio manager Steven has experience in both front office investing and how the front office links with mid/back office and risk management. He has consulting experience in various types of RFP processes and benchmarking exercises.