Today we find ourselves in a similar juncture in the investment community, where policies from abroad must be synthesised with homegrown ones. For over a decade now, the EU has attempted to increase transparency in the production of research in the financial services sector with a legislative framework known as MiFID.
Chief among those policies was the unbundling of research costs from execution payments – meaning that investment banks are forced to disclose the breakdown of the fees that they charge. As such, these financial behemoths have had some unwanted attention, given that these costs were often exorbitant.
Sometimes clients would feel shortchanged, as they did not make use of the research services, or they did not value them in that price range. It’s akin to going to a nice steakhouse, looking at the bill and seeing that they’re charging a fortune for the breadsticks you might not have even touched.
MiFID is now in its second iteration after the first one was exposed to have some weaknesses. Originally, it focused too much on stocks, to the detriment of other asset classes, and did not address business done outside of the EU’s jurisdiction. This has been amended, and thus whether it wanted to or not, the rest of the world has been dragged into the MiFID II sphere of influence.
I was surprised by the global ad hoc adoption of MiFID II by the larger asset managers, who decided it was easier to take a uniform approach rather than manage Europe separately. To do otherwise would mean too many additional headaches. Subsequently, the SEC has attempted to formalise this new relation by asking Wall Street for its feedback to help create new policies bridging the two legal and financial frameworks.
There are three main areas, where I think Wall Street would benefit from assessing properly:
- Peppercorn Pricing – here we are back to our overpriced steak dinner. Whereupon seeing the unhappy reviews we left the establishment for overcharging us on basic services, they have now become very sneaky and reduced the price of the breadsticks (research) but baked the true cost into the price of the steak (corporate finance). Hence, they misdirect their clients by obfuscating the true cost of the services they provide; and thereby charge far more than consumers would be willing to pay if they knew the true costs. This protects them from competition from research firms that cannot subsidise bloated price tags by syphoning resources from elsewhere.
- Best Execution – Brokers are required by law to provide the best order execution for their clients, ensuring the best price and speed given the present market conditions. However admirable, this is now at odds with the consequences of MiFID II. How can brokers prove best execution is applied when the quantity and quality of research have declined? Any further direction on this regulation should address this conflict of interests.
- Small/Midcap stock research – Transparency around research costs has forced banks to prioritise research on household names. According to recent StarMine figures put together by Bank of America, since 2011, companies with a market value between $10bn and $100bn have seen their coverage shrink by 26%, and analysts investigating these firms have dropped by a fifth.
By dedicating even more resources on well-established companies, investors seeking alpha are short-changed and the economy’s dynamism is eroded, as contenders are starved of financial resources.
One idea that needs further research might include a portfolio quota requiring a certain diversification across market capitalizations. This policy would then result in the dispersion of capital and research across the equity markets; as well as also create opportunities for smaller, and nimbler research firms that can investigate these sectors but don’t profit from companies trading those stocks.
History teaches us that the desire to wall the local economy off from the outside world diminished when the vested interests of the oligarchs were sidestepped. In future, I suspect a similar thing will happen when nimbler research firms diffuse the power of the big entities and give it back to the investors.
The adaptation of MiFID into the wider American system is but the latest portion of the saga in the harmonisation of economic policies worldwide. We do not ultimately know how it will end; but if history is any guide, the world will become smaller, and by bringing each other closer than we’ve been before, perhaps we’ll understand each other better.
Joshua Maxey is managing director and co-founder of Third Bridge, a global independent research provider serving the world’s foremost hedge funds, mutual funds, private equity firms and strategy consultants.