Asked by a financial regulatory consultancy about their plans for MiFID II, wealth managers recently said they would need an eye-watering 1,363 working days on average to meet the new requirements – and that’s excluding the necessary IT development. This more or less means that any firms who haven’t yet started preparing face a mountain ahead of them: no less than five years’ worth of work to be done in less than a year.
It’s no secret that even the savviest of wealth managers are losing their hair over the gathering tsunami of regulatory burdens, but many don’t appreciate just how unprepared they are for the new rules. What exactly is it, though, that has them quaking in their boots, and just how extensive is the problem?
One of the big ideas behind the original MiFID rules was to tackle the culture of inducements. Inducements are essentially extra benefits offered to asset managers by third parties to entice them into processing trades with them – benefits which aren’t strictly related to the trade itself.
The blockbuster sequel in the gripping saga – MiFID II – makes a big deal of inducements related to the research and analysis that the finance industry pumps into every trade and investment decision. For decades, banks and brokerages (which house the ‘sellside’ of the research world) would try to sweeten the deal for asset managers (the ‘buyside’) by offering services like analyst reports and access to top-level managers as part of their commissions. This meant they would more or less bundle things which asset managers find attractive, but which don’t necessarily benefit the clients.
Why is this happening in the first place? Because some services might give a fund manager the edge by boosting their business as a whole, but they might not be suited to the particular strategies or desires of individual clients. Why would clients looking for high growth want to pay for reams of reports from bond analysts, for example, or clients wanting low-risk services for phone calls with frontier market experts? This is the idea behind MiFID II: to make sure that it’s only a fund manager’s client who calls the shots on how their money is spent.
The Beauty of MiFID II
MiFID II is all about increasing transparency. A huge part of it is making the sellside ‘unbundle’ their research from their trading costs. This includes a host of rules, including forcing banks to break down their commission costs explicitly to their clients and having them sign off on research expenditures.
The beauty of MiFID II is its scope for boosting competition. Investors can see how much they pay for research as opposed to execution, and decide whether they are on board with it, so research providers will have to work round the clock assuring clients of the value of their work. What’s more, harmonising what are currently quite different regulatory environments in various countries means that more firms will be able to compete for more customers.
It’s not as simple as it sounds, of course. As with every regulatory mammoth, it raises numerous questions and complications when you get into the details.
For example, firms generally have multiple funds, for which particular chunks of research might come in handy to wildly different degrees. Each fund, of course, has its own set of investors to answer to. So how do managers decide to split the research budget and how do you pay for research services when the budget in one fund has been spent?
Each decision of that kind comes with a myriad of potential pitfalls. For example, VAT charges on research that gets shared between different analysts, and, subsequently, used for different firms, present a monster of a problem for accounting. Then, there are timing issues: some investors might join a fund before it hits its research budget, while others might join afterwards. Who pays what?
Countless Ifs and Buts
Firms will have to sink endless hours into these issues in order to have any hope of achieving compliance – and all the more so, given that the value of research and analysis is a rather difficult thing to quantify and track.
But, for better or for worse, regulators have decided that it must be so. The idea is that a vast quantity of research is going unused, or is effectively redundant. Firms on the buyside, for example, might get dozens or even hundreds of reports from brokers and other sellside analysts, which are more or less the same.
The thing is, asset managers already know this very well – that’s a major reason why only 2-5% of research emails even get read (so say industry insiders, according to the FT).
In fact, investors have also been laying on the pressure for analysis expenses to be justified for some time now – and with more and more success, as record low levels of market volatility squeeze active fund managers’ profit margins, pushing the cash to more technologically-driven models.
Transforming Wealth Management
So this is indeed taking effect. About three quarters of the asset managers surveyed by the Electronic Research Interchange (ERIC) said they were likely to reduce the amount of investment bank research that they subscribe to. BCA Research, meanwhile, estimates that portfolio managers get about 500 analyst reports on average each day, a figure they reckon will fall by about 20% under the new regime. This represents a potentially huge haircut on that $16bn-a-year figure for research budgets.
At a recent Bloomberg conference it was quoted that only a few years ago a new user would ask all sellside research permissions to be switched on so they could receive waterfront coverage, but now the trend has totally reversed – a new user would ask to only be ‘permissioned’ for research coverage that they are paying for.
Bigger buyside firms can just pay for more of their research out of their own pockets. Asset managers are beefing up their in-house research teams, and sellside research is losing its shine. ERIC’s survey also found that three quarters of asset managers plan to start scrutinising their sources of research more heavily from January 2018, and 38% of them are looking at expanding their internal research teams.
The potential overhaul in the industry goes beyond buyside versus sellside. For example, among asset managers, mid-sized firms who don’t have the resources or positioning to handle the change are set to lose out quickly.
The Death of the Sellside?
This trend is why many pundits are already calling time on the sellside research business – but MiFID II looks set to turbo-charge it. Rather than leave it to market forces to slowly turn up the heat on bankers’ and brokers’ commissions, the new rules will throw them feet first into the fire by laying the ins and outs of their research budgets out for their investors to scrutinise. If the sellside as we know it isn’t dead just yet, it will certainly look more like it come 2018.
The industry seems to realise this to some extent: a survey by Quinlan & Associates found that worldwide asset managers plan on cutting their budgets for analyst research by 30%. Zeroing in on Europe, this figure rises to 50%.
Yes, some banks are starting to adapt to the new environment, but it’s far from clear whether this is the dramatic change that is needed for their business models to mesh with the new MiFID world: Extel data shows there are still 465 bank research teams covering banking stocks, for example, and 263 teams covering telecoms and IT stocks. And, perhaps most strikingly, ERIC’s European Asset Management Survey found that almost 40% of asset managers aren’t ready for the ‘unbundling’ of research costs.
Jumping the Gun
The problem is that dragging resources from the sellside to the buyside doesn’t completely solve the issues that MiFID II sets out to address. To go back to the ‘useless’ research reports – there’s a reason why managers keep paying for the whole service despite only opening a fraction of those emails. They’re often paying for people to make good calls on stocks, for example, or to get access to management teams.
If demand for research like the tens of thousands of ‘redundant’ reports plummets under the new MiFID regime, that will leave services like management access with far more value – meaning that independent research providers who specialise in linking people with people, managers with experts, and so on, will already be well-positioned to offer the most attractive services in the brave new world.
As for the rest of them – well, if they don’t start knuckling down soon, we can only wish them luck.
Nurturing their in-house research teams might have worked in response to the gradual shift in the industry so far. But if firms choose to duplicate this in response to MiFID II, they might be jumping the gun. Asset managers are failing to sit down with the new rulebook and rationally weigh up the cost-benefit analysis. They are stuck. They can expand and develop in-house research, which will lower profits, but this also begs the question as to whether they can they retain key talent if salaries are reduced by trying to keep a lid on costs. Another option is to charge higher management fees, which will make the net performance even worse in an environment where fees are already under pressure.
Finally, they can also choose to make investments into MiFID II compliance and incur greater costs. The latter is also a real issue for smaller investment managers and therefore we can expect to see more consolidation in the asset management space.
There are some 200 days until MiFID II comes into effect. The fact that so many managers seem to have yet to start preparing might mean that they will rush to pick the easiest available option, whatever that might be. However, the path of least resistance rarely leads to the right place.