“It works in practice, but does it work in theory?” No one knows who first uttered this quip, but it has been applied to scientists, economists and politicians. It also applies to European financial regulators.
In early 2014 — with robust British backing — the European Union agreed rules under the 30,000-page Mifid II financial reform to separate trade execution fees from broker research costs. The “unbundling” requirements came into force four years later.
Fast forward to today, and regulators are now repenting at leisure. The EU last year started consultations to dismantle these rules. And now the UK is undertaking its own volte-face, following the Investment Research Review’s recommendation to give investors more flexibility in how to pay for research.
As MainFT explains:
Asset managers should be able to pay for their investment research alongside fees for trading, the UK market regulator has proposed, reversing a long-standing policy in an effort to energise the UK’s capital markets.
The Financial Conduct Authority on Wednesday said fund managers should be able to “bundle” fees for investment bank research with their trading costs….
Its proposal would row back on an important plank of Mifid II . . . spearheaded by London’s politicians and regulators.
Before Mifid II, brokers bundled research with trading fees, like McDonald’s throwing in a free toy with a Happy Meal. The cost of research was not paid directly but rather via the “soft dollars” of trading commissions.
But starting with the Myners Report in 2001, critics argued that the package deal created a conflict of interest, incentivising portfolio managers to send trades to the broker providing the most or best research, not the most cost-effective execution.
The solution seemed straightforward: separate research costs from trading commissions. This would enhance transparency and prevent fund managers from sneakily passing research expenses on to their clients under the dark cover of dealing costs.
Whatever the theoretical merits of unbundling, it really hasn’t been necessary.
For one thing, the financial savings are trivial. According to the FCA’s recent report, the cost of external research from 2018-2023 amounted to 0.01-0.03 per cent of total equity assets under management. This suggests that pre-Mifid II research costs had a negligible effect on investor returns. In other words, the unbundling reforms amounted to a Brobdingnagian effort to address a Lilliputian issue.
Moreover, the market had evolved to enable fund managers to reward investment advisory without compromising trade execution. As Philip Middleton of STJ Advisors notes, commission sharing accounts (CSAs) allowed investors to trade with their favoured broker and then split the commission among different firms to recognise research and advice. CSAs weren’t perfect, but they worked well enough.
The CSA set-up didn’t assuage regulator concerns, however, and so Mifid II rules were introduced to force brokers to charge separately for trading and research, effectively requiring portfolio managers to pay for research from their own revenues.
But as the Duke of Albany warns King Lear, “Striving to better, oft we mar what’s well.”
By making the cost explicit to fund managers, the unbundling rules prompted them to slash research budgets. While the cost of research is tiny as a percentage of assets under management, it can amount to the second or third largest expense item (after compensation and technology) for fund managers when the cost is transferred to their income statement.
Mifid II has ended up reducing the number of companies under research coverage, harming liquidity, and decimating the ranks of sellside analysts. Cheaper junior analysts have supplanted senior ones. Independent research firms have suffered as well, feeling the competitive squeeze from the cut-price packages of the big banks. In addition, reforms have introduced new friction, Balkanising service delivery in ways that does no one any favours.
Beyond the unintended consequences, the regulatory crusade also overlooked the public good of investment banking research.
Sell-side research is often derided, but even if you disregard the investment recommendations (as almost all professional investors do), it still has value. The reports provide a repository of forecasts and models which investors can then use for their own work.
Like a quality newspaper, research offers a fast-track way to get up to speed on a company or situation, even if you shouldn’t uncritically accept the content. Broker coverage generates interest and engagement, potentially resulting in deeper trading liquidity, superior price discovery, and a lower cost of capital. It’s unfashionable to say, but research has positive externalities, even if analysts are wrong much of the time.
It’s a relief that the UK and EU are reversing course. But after banks and asset managers have spent billions of dollars to comply with Mifid II, it’s probably too late to repair most of the damage. The trend is not the friend of sellside research.
For one thing, fund management firms have adjusted their modus operandi, and path dependency limits the scope for change. With smaller commissions going to fewer brokers, it will be a challenge for brokers to push through rate increases on account of rebundling research.
Investors have also implemented new protocols (with attendant internal bureaucracies) purportedly to assess the value they receive from broker research they’re paying for (but really to document compliance with Mifid II). Anyone who has worked in a large organisation knows how difficult practically — and fraught legally — it is to dismantle these kinds of apparatus.
Moreover, the number of listed companies has also declined significantly in London and in the EU. The IPO market’s nascent recovery isn’t nearly enough to refill the hopper or warrant recruiting an army of new analysts.
So like other parts of the cash equities ecosystem, sellside analysts had been under pressure even before Mifid II. The unbundling rules effectively kicked the broker research business while it was already down. It will struggle to get back on its feet.
In sum, regulators upended the broker research industry to address a piddling problem, disrupting a system that faced commercial challenges but wasn’t discernibly broken. Bundling had offered convenience and economies of scale and enabled a wide range of companies to be covered. If there were hidden costs, they were inconsequential for investor returns.
It worked fine in practice, but not well enough in theory to appease regulators.
