U.S. to Study Effects of MiFID II Research Unbundling
By Ivy Schmerken
U.S. lawmakers authorized a study focusing on the provision of investment research for small issuers, a sign they are wary of the U.S. adopting the European Union’s MIFID II unbundling rules which have brought sweeping changes to the research business.
On July 9, the House of Representatives passed a bipartisan bill requiring the Securities and Exchange Commission to study the provision of investment research into small issuers including emerging growth companies and companies considering initial public offerings. The bill has been sent to the Senate where it has been passed onto the Committee for Banking, Housing and Urban Affairs.
The bill (HR2919), known as “Improving Investment Research for Small and Emerging Issuers Act,” will require the SEC to explore a broad range of issues. Among the issues the study will consider are: demand for research by institutional and retail investors; the availability of research in terms of number and types of providers; the volume of research over time; competition in the research market; costs of such research as well as conflicts of interest in the production and distribution process. In addition, the study will consider the effects of concentration and consolidation on fund managers including the size of fund managers and how this relates to the demand for research.
But perhaps most relevant to MiFID II, the study will examine the impact of different payment mechanisms on research. This will include hard dollar payments from clients, payments from commission income directed by clients — a.k.a., soft dollars as allowed in the U.S. — or payments from the issuer that is the focus of such research.
On the regulatory front the study will look at the impact of the SEC’s rules, the EU’s Markets in Financial Instrument’s Directive (MiFID) and the Global Research Analyst Settlement.
If approved by the Senate, the SEC will have six months (or 180 days after the legislation is enacted) to conduct the study and submit a report to Congress that includes recommendations “to increase the demand for, volume of and quality of” investment research for small issuers.
The timing of the study overlaps with the SEC’s invitation to submit comment letters on the idea of implementing a cross-border approach to the EU’s MiFID II research rules. The SEC has invited broker dealers, investment advisers and others to submit comment letters on MiFID II related to the regulatory compliance challenges posed to U.S. firms and on research provision.
Reductions in research coverage for small and medium-sized companies has often been considered the “unintended consequence” of MiFID II’s unbundling rules.
In a speech to the SEC Investor Advisory Committee on March 28, SEC Chairman Jay Clayton said he was “concerned that the broad availability of research may be reduced as a result of MiFID II.”
In particular, Clayton asked commentators to address the following: Has MiFID II reduced the supply of research overall and/or the availability of research from a variety of broker-dealers, including smaller and specialized firms? Has MiFID II reduced the quality of research overall or in particular sectors or for particular size issuers? More particularly, are advisers encountering challenges in obtaining the coverage and quality in research that they need to support their advisory services?
According to a UK and EU investor survey conducted in December of 2018 by Peel Hunt LLC and Quoted Companies Alliance (QCA), MiFID II rules have led to a decline in research produced, reported FT Adviser. Nearly two-thirds or 62% of investors reported there is less research being produced on small and midcaps since MiFID II went into effect. Meanwhile, 63% believe that MiFID led to a decline in liquidity for small-cap shares. The poll is based on 102 UK-based fund managers and 105 small- and mid-sized quoted companies.
In March, CFA Institute released a study about MiFID II based on members in the EU, UK and Switzerland, finding there’s a negative effect in terms of employment in the research business, with the buy side sourcing less research and most respondents citing a reduction in sell-side analyst jobs. According to the CFA study, 44% of sell-side respondents believe that small- and mid-cap research has deteriorated, “which is a concern given that improving the provision of this kind of research was a polity goal of the directive,” wrote Sviatoslav Rosov, Director of Capital Markets Policy EMEA at CFA Institute in “MiFID II Research Unbundling: A Survey Yielding Mixed Results:. “Irrespective of quality, the coverage of small- and mid-cap stocks has decreased according to 47% of buy-side and 53% of sell-side respondents,” added Rosov.
To Adopt or Not to Adopt
Presumably aware of these results from earlier studies, U.S. lawmakers may be looking for reasons not to adopt some of MiFID II’s unbundling rules. According to the Integrity Research blog, “US Congress Proposes MiFID II Study,” the law enacted by the House is only going to reinforce the SEC’s hesitation to expand MiFID II’s unbundling rules to the U.S. But as US comment letters suggest, there is still debate over how MiFID II has affected the quantity and quality of research on small issuers.
“Often remarked as the major unintended consequence of research unbundling, small and medium company research coverage has not fallen as much as predicted. On our own platform, we have not observed a material drop in coverage,” wrote Vicky Sanders, Co-CEO of RSRCHXchange, an aggregation platform and research marketplace that was acquired by Liquidnet on May 13.
Sanders noted that the number of analysts per stock listed on London’s AIM (formerly Alternative Investment Market) rose 7.6 percent since MiFID II came in on Jan. 3 last year, citing data from Hardman & Co. In addition, coverage of mid-cap AIM stocks (valuations of $255m-$766 m) increased by 11.3 percent, according to Hardman & Co.’s data.
Based on RSRCH Exchange’s own Q2 survey of nearly 350 asset managers on its platform, it found that 82% of respondents agreed that low prices paid for research may cause a decline in the coverage of small- and mid-cap companies.
As a result of MiFID II unbundling rules which took effect on Jan. 3, 2018, investment firms that are paying for research through their own P&Ls have become more cost conscious. Investment managers are also required to put a price on research, which has led them to renegotiate their contracts with sell-side firms, which in turn has exerted downward pressure on prices.
Due to lower prices for written research, independent research providers are at a disadvantage, wrote Sanders discussing the platform’s study. In the survey, 75% of respondents felt that lower prices are not sustainable. The pain is mainly felt by independent research providers rather than large broker dealers, wrote Sanders.
In a bundled commission world, research coverage is linked to trade volumes, so that large cap stocks may have 50 analysts covering them, noted the RSRCHXchange study. However, MiFID II could lead to a shakeout in the research business. Market forces could pull talented analysts away from liquid stocks toward coverage of less liquid small- and mid-cap stocks where there is an unmet need and where analysts can generate alpha.
A second research platform operator said there were concerns prior to MiFID II about the potential drop off in coverage in the mid- and small-cap space. “It is early days, but this doesn’t seem to be the case in Europe with only a small slippage in coverage,” wrote Scott Duxbury, Co-founder of Nucleus195, on March 11. An online research marketplace based in Stamford, Conn., Nucleus195 has spent the past 18 months speaking with research providers – broker dealers and independent research providers.
While research coverage may not have declined by much, Duxbury points out that other types of company-paid-for research have surfaced as a result of MiFID II. “It has resulted in the rise of company-sponsored research through which you could mask those numbers. Whilst having coverage is great, many investors question the biased basis of paid research,” wrote Duxbury.
In the U.S., some of the comment letters make a strong case for unbundling research payments from executions, emphasizing the fact that investment managers should only have to pay for the research they want to buy.
“Institutions have been adopting the unbundled model even if not required to. They are seeing benefits of not having to pay for research that they do not need. They prefer being unbundled as they are not ‘forced’ to pay for research they don’t want,” wrote Duxbury.
By conducting the study, the SEC will also be able to examine whether a lack of research coverage into small issuers could be preventing them from conducting initial public offerings in equity markets.
Meanwhile, the SEC has indicated it plans to extend an exemption that allows U.S. brokers to sell research to European fund managers that fall under the MiFID II regime, according to the Financial Times. U.S. broker dealers are not allowed to accept direct payments for research, unless they register as investment advisers, which they argued was another layer of regulatory burden. If the SEC extends the no-action letters put forth in October of 2017, that are due to expire in July 2020, then U.S. brokers will gain a reprieve for as long as three years, reported the FT. However, this may not solve the regulatory inconsistencies faced by U.S. asset managers.
Even if lawmakers would like to avoid MiFID II with its overhaul of the research business and potential effect on small issuers, they won’t be able to ignore it. Some U.S, large asset managers have decided to voluntarily pay for research so that they could still receive research from European brokers when MiFID II took effect.
Last week, T. Rowe Price became the largest and latest asset manager to say they would pay for third-party research globally. The Baltimore-based fund manager began paying for investment research used by its UK-based investment manager, T. Rowe Price International, across its European operations on Jan 3 2018 in line with MiFID II requirements, reported Investment Week. Starting Jan 1st, T. Rowe said it will pay any broker that accepts hard dollars, and for those who don’t, it will utilize commission sharing agreements and reimburse its end clients.
“This decision maintains our access to high quality and value-added third-party investment research that is additive to our investment process and benefits our client portfolios,” said the firm in a statement.
Although asset managers say they value research, they have cut research budgets by 20% to 30% since MiFID II went into force. Research commissions are estimated to fall to $13.8 billion from $16.9 billion in 2015, according Integrity Research. While this is saving money for investors, it has the potential to drive some research providers out of business. Consolidation is already underway. For example, AllianceBernstein acquired Autonomous Next, a provider of financial services and fintech research, in April 2019, citing its commitment to fundamental research.
But any reduction in research capacity that results from MiFID II could unsettle US lawmakers, brokerage firms and independent research providers. It’s uncertain how regulators will react since large global fund managers are clamoring for a uniform approach to research payments, while Congress wants to ensure coverage of small-cap issuers. No doubt the research study will shed more light on these issues, while the SEC postpones a final reckoning with MiFID II.
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