From Unbundling to Rebundling

The following article first appeared as FLASH FRIDAY on Traders Magazine. FLASH FRIDAY is a weekly content series looking at the past, present and future of capital markets trading and technology. FLASH FRIDAY is sponsored by Instinet.

By Chris Hall

We all know you can’t turn back the clock. And you can’t put the genie back in the bottle. But European regulators are attempting to pull off something similar by partially reversing a ban on bundled research and execution payments, causing confusion and uncertainty over here in the US.

Mett Kinak, T. Rowe Price

“Exempting small-cap stocks from the research unbundling is the equivalent of trying to put the toothpaste back in the tube,” said Mett Kinak, global head of systematic trading and market structure at T Rowe Price. 

Having codified the global shift toward full separation of research and execution payments, with the introduction of MiFID II in 2018, the European Commission unveiled proposals in July to water down its own regulations on research payments. 

Consultation on the plans – issued as part of a package to support the recovery of European businesses from the economic impact of the Covid-19 pandemic – closed earlier this month. Many are keen for the release of more details, including the US Securities and Exchange Commission (SEC), ahead of the rules coming into force, which is expected early next year. 

By exempting research on firms with a market capitalization below €1 million ($1.15 million) from MiFID II’s unbundling rules, the intention is to increase the availability of research into small- and mid-cap stocks, thus stimulating much-needed investment flows. 

MiFID II has had extra-territorial consequences, crystalizing evolving best practice at major asset management firms, and leading to a global consensus that research must be paid for directly by the asset manager, separate from trading commissions, and not passed on to the end-investor. 

Rewind a few years — an April 2017 article published in Traders Magazine gave the state of play at the time:

“The incoming rules separating payments for trading and research in the European Union will expand beyond the region and are likely to boost full unbundling of client commissions around the world.

MiFID II, the regulations covering financial markets in the EU, come into effect at the beginning of next year. One of the requirements of MiFID II is to separate payments for research from trading commissions to increase transparency and reduce conflicts of interest. Asset managers will have to either pay for research out of their own P&L or from research payment accounts, where they have agreed a budget with their clients. The requirements cover fixed income, currency and commodity markets for the first and the buyside will also have to track their consumption of research and evaluate its quality.”

US-based investment firms were permitted to effect this change via no action letters issued by the SEC, due to expire July 2023, which allow broker-dealers to receive payments for research from investment firms if the latter are required by MiFID II to unbundle. This means many US-based asset managers now pay for their own research at home and abroad. T Rowe Price, for example, has been paying for all its own research costs globally, either directly or by reimbursement, since the beginning of 2020.

It is possible that the proposed exemption for research into small- and mid-cap stocks could conflict with the requirement on which the SEC’s no action letters are based. And, having recently explained the initial shift to end-investors, some heads of trading are not looking forward to telling institutional clients that they may need to pay for research when investing in funds registered in one jurisdiction, but not if investing in funds registered elsewhere. Others are more sanguine. 

“It can be a little confusing and time-consuming, in terms of what you pay to whom and where. Ideally, you’d like it to be more consistent, but as regulations change you just have to adapt,” said David Lewis, head of global equity group trading at Franklin Templeton.

In January, a report by the French financial market regulator, the AMF, blamed MiFID II for declining research coverage in smaller companies. Earlier this month, a report by the European Securities and Markets Authority asserted that MiFID II had had no meaningful impact, citing a study which found there had been a steady decline in research coverage since 2012.  

In MiFID II’s pre-legislation consultation period, many across the industry expressed fears that the introduction of greater transparency in research payments could reduce the availability of small- and mid-cap research, with inevitable knock-on consequences for liquidity and spreads. 

“Pre-MiFID II, we argued vehemently that small-cap stocks should not be bound by the new unbundling rules, because that was where research would be hit hardest and is most needed. Now we’ve unbundled and we’re paying for our own research, and there are proposals suggesting it’s ok for our clients to pay for small-cap research,” explained Kinak. 

The European Commission’s proposed exemption may mark a wider change in tone, according to Tim O’Halloran, managing director at Tourmaline Partners, a provider of trading and commission management solutions. “The broad regulatory trend over the past 5-10 years has been toward unbundling, greater transparency and a competitive research marketplace. This sends a message that commissions are still going to be the currency of exchange for research in some capacity.” 

But Mike Kronenberg, co-founder and CEO of Analyst Hub, a platform for independent research providers, predicts that the proposed exemption will have minimal initial impact on the largest asset managers. “Institutional buy-side firms have put very strict policies in place,” for the onboarding of research, he said. “For the top commission payers, those policies and procedures are going to remain, with perhaps a relaxation for one or two specialist portfolio managers.”

There is also a political dimension which could make the picture even more complicated for global asset managers operating across multiple jurisdictions. With the UK potentially leaving the European Union without a trade agreement at the end of this year, it is highly unlikely that the Financial Conduct Authority would implement the European Commission’s proposed changes to MiFID II. Much of the initial impetus behind the separation of execution and research costs came from the UK regulator’s predecessor. This means funds registered in the departing UK may stick to MiFID II’s original intentions, whilst the remaining EU-27 row back. 

The British might describe this as irony. Kinak calls it confusing. “With Brexit looming, there’s potential for even more divergence of regimes, with UK-registered entities subject to different rules from European ones. Clearly, that would make for further complexity,” he said. 

A spokesperson confirmed to Traders Magazine via email that the Commission is currently analyzing consultation responses to decide whether additional changes should be inserted in the draft text. “The final rules on research will be adopted shortly,” the spokesperson said.

Chris Hall is a Senior Correspondent for Traders Magazine. Chris can be reached at [email protected]

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