For anyone outside the world of financial services, the ushering in of Mifid II last week will have gone largely unnoticed. With an estimated 1.7 million paragraphs of new legislation, guidance and rules, this is a blessing.
Mifid II, or the Markets in Financial Instruments Directive II, to give it its full name, is arguably one of the most seismic events in the financial services industry for a generation. At its core, key objectives are to strengthen investor protection, increase efficiency and reduce systematic risks across European financial markets. At face value, all admirable aspirations.
One of the key changes under this new regulation surrounds the provision of investment research by brokers. Until January 3 this year, the usual modus operandi was for brokers to make their research available to a wide range of market participants in the hope – and belief – they would be rewarded by commission when the third party traded shares through their dealing desks. No more. Such activity is seen under Mifid II as an inducement by the broker to gain trading revenue ultimately paid for by investors.
Going forward, fund managers must choose to either bear the cost of research from their own pockets (for example by paying brokers an annual fee for continued access to their research) or establish a clearly defined research budget pool to be paid by investors. Anecdotally, whereas suggested fees for access to research at some of the larger London-based banks and brokers started in the hundreds of thousands of pounds per annum six months ago, the market seems to have found a level at a fraction of this price.
The logical implication of this is a significant reduction in commission rates as equity trading becomes more commoditised with little or no value add over and above the execution of the share transaction. So far, so good. But with less money to go round, there will also be a natural reduction in the amount of research available on the UK’s quoted companies.
Whilst this matters less at the large cap end (there is no shortage of larger banks covering BP, for example), it is not uncommon at present for companies under a £250m market capitalisation (these are still, in anything other than stock market terms, large companies) to have only a handful of brokers covering the stock (i.e. writing research comment) and, for those with market caps under about £100m, there may only be one – the house broker.
In the new regime, brokers will be reluctant to allocate resource to investment research where there is no clearly defined return either through trading commission or some form of corporate broking mandate. Furthermore, those brokers who do continue to write research will be restricted as to where they can distribute it: they can only send such comment to fund managers who have agreed to pay them, otherwise it may be classed as an inducement.
So what is the future for small and mid-cap quoted companies? Mifid II provides a carve out for so-called Issuer-Sponsored research, i.e. research that has ultimately been paid for by the subject company itself. This could include a specific paid-for research service or where a broker acts as corporate adviser for which it is clearly and contractually remunerated for providing a research service. This is the route that WH Ireland has taken. The benefit to this approach is that research for corporate clients of the firm can continue to be distributed to a wide investor audience as it is not seen as an inducement to trade. The downside is that the cost of this research will have to be borne by the company itself, whilst conflicts of interest need to be carefully managed and disclosed.
Whilst still very early days, confusion reigns with not every broker having fully decided yet which route to go down. Until the dust settles, Mifid II has the potential to severely disrupt and reduce liquidity at the smaller end of market as investors try to cope with a dearth of information. The likely long-term end-point is that quoted companies will foot more of the bill for research themselves and the use of joint or junior brokers will become more commonplace as a way of ensuring as broad an investor reach as possible.