By Stephane Loiseau, Managing Director, Head of Cash Equities & Global Execution Services – Asia Pacific, Société Générale
MiFID II’s commission unbundling provisions will have a widespread impact on global financial services and lead to the emergence of more independent research platforms.
The implementation of MiFID (Markets in Financial Instruments Directive) I a decade ago established a harmonised investment services framework in Europe. It also led to a wide-spread adoption of low-key unbundling of stock trading commissions, separating a broker’s advisory service from order execution.
However, MiFID II, which will come into force on 3 January 2018, will have much more explicit prescriptions and a wider ranging impact, affecting not just how European fund managers conduct business, but also on buy-side firms in Asia and the US.
The legislation considers payment for research (or any other service) through trade execution commissions an inducement and is therefore not allowed. The regime also sets tougher rules on the transparency of research costs, which must be disclosed by asset managers.
It is likely that the regulation will equally impact US and Asia firms whether they trade in the EU or not. It also means that US and Asia subsidiaries in the EU will have to conform.
Currently, there is limited unbundling of trade commissions and research in Asia, mainly due to the complexity and diversity of the region’s markets. Yet, there has been a prevailing awareness that advisory services and order execution should be separated, albeit informally. The advent of MiFID II has hardened the perspective, solidifying a previously nebulous undertaking to distinguish between the two services.
In the US, where the Securities and Exchange Commission prohibits cash payment for research from the profit and loss account, a majority of fund managers said according to various press reports that MiFID II is likely to have an impact on their business models as they intend to unbundle commissions, although it’s not clear how they will do so or even value research.
Global adoption of unbundling
There are two main reasons why Asia and US fund managers are becoming more MiFID II aware. First, there is a commercial motive: they operate in a highly competitive market, and asset owners are likely to select fund managers who demonstrate best practice. This is especially important when pitching for sovereign fund mandates in Asia and the Middle East whose activities are subject to close public scrutiny, and where maximizing performance, therefore also minimizing costs, are amongst the key objectives.
Second, there is a business imperative: the scope of MiFID II outside Europe is still unclear, but it is likely to be wide and probably extra-territorial, so fund managers need to be prepared to avoid being blindsided, while adoption on a worldwide basis will facilitate internal operational efficiency for the largest firms.
The MiFID II provisions cover all types of research, including macroeconomic analysis and strategic advice, as well as stock, rates and credit recommendations. Although the separation of trade execution and research costs for equities has already been applied by some buy-side firms, fixed income is entering new territory. There are no explicit commissions paid for dealing in bonds, and there is no connection between research costs and trading spreads.
For all asset classes, the sell-side needs to determine how the buy-side should pay for different components and methods of delivery, distinguishing between basic web content, discrete research portals and premium services such access to a star analyst, strategist or economist.
Meanwhile, a buy-side firm basically has three options for allocating costs. First, the transactional method funds a Research Payment Account (RPA) that incorporates a Commission Sharing Agreement (CSA) with sell-side firms, separating trade execution costs from research costs.
Second, the accounting method funds segregated Research Payment Accounts (RPA) internally, matching invoices from research providers with their application to clients’ proportional interest in a portfolio. The third way is simply to pay for research from the firm’s profits. This has the attraction of being subject to less regulatory oversight, but some firms might take one of the two RPA routes if they have already implemented a degree of payment unbundling and allocation system for their clients.
Certainly, the adoption of the RPA method will make buy-side firms more aware of the value of specific research and this closer scrutiny will put pressure on sell-side firms to produce consistently high-quality content.
An unforeseen consequence of MiFID II’s rule might be concentration risk, with fewer banks and brokerages providing research and a reduction in trade execution counterparties as some sell-side firms, starved of commission income, pull out of markets. Perversely, this could lead to a re-bundling, creating an oligopoly between the largest investment banks and asset managers.
Independent research platforms
On the other hand, independent research providers should be given a boost. Regulation is pushing buy-side firms towards them in order to ensure there is no suspicion of tacit links between trade execution and research, and independent firms with low costs should be able to compete on price with banks and brokerages struggling with high fixed costs and vulnerable revenue streams.
However, research specialists need to establish credibility with fund managers, especially if they are a new entrant to the market up against well-established bank incumbents. There are companies that aggregate research, package and sell it to fund managers, but an alternative model, that takes advantage of new technologies, offers a more efficient and customised service.
Last year, Société Générale signed an agreement with “Smartkarma”, a curated online platform for investment insight focused on the Asian markets, to provide its institutional clients access to equity research based on real-time demand and matched to individual investment mandates using predictive technology.
Customers receive research provided by around 400 highly ranked analysts, academics, data scientists and strategists covering more than 1600 companies across 15 Asian markets. Many of the analysts previously worked at major financial institutions and prefer the independence of working in smaller, autonomous firms.
A platform such as Smartkama offers fund managers an ecosystem that is fully compliant with MiFID II’s unbundling prescriptions, avoiding suspicions of brokerage inducement while ensuring access to the best research, judged on its own merits.
Independent research platforms are likely to develop further as many sell-side firms are forced to choose between maintaining costly own research capabilities or focussing on trade execution. A bifurcation of function seems to be an inevitable consequence of MiFID II’s unbundling provisions.
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