The unbundling of research from trading commissions represents a major change in the way banks and brokerages produce analysis for their clients and the French supervisor has taken a lead in this debate by appealing for a level playing field and an end to ‘gold-plating’. By Justin Pugsley.
What is happening?
As part of the Markets in Financial Instruments Directive II (MiFID II), EU-based fund managers will have to pay for research either out of their profit and loss accounts or set up ring-fenced research accounts.
This may not seem like a big deal, but it will affect the type of research produced by the sell side, namely investment banks and brokers. And it will affect the buy side – that is, asset managers – as they will have to demonstrate that they have paid for research they have obtained.
Though the move has been mooted for some time, a recent consultation from the French regulator Autorité des Marchés Financiers (AMF) could influence its implementation. It appears to be an attempt to ensure a level playing field across the EU and to stop ‘gold plating’.
Indeed, the AMF has become quite influential in the unbundling debate and might be exploiting the UK’s rapidly diminishing influence on EU policy-making following the Brexit vote. The UK has been pursuing its own agenda on unbundling for more than a decade and heavily influenced the drafting of MiFID II on this topic, which alienated some of its continental peers.
Why is it happening?
Investment banks and brokers had a practice of handing out ‘free’ research to clients so that their recommendations would generate trades and hence brokerage commissions. In other words, it was often a form of marketing, so nearly all equities research, for example, only contained buy recommendations.
European regulators spotted the conflict of interest and were concerned asset managers may have been relying on research that was not primarily designed to make money for investors, but rather for investment banks and brokers.
From January 3, 2018, research cannot be used as inducement for business across the EU. The buy side will not only have to pay for it, but will have to show that it has done so.
This will be less transformative in the UK, where commission sharing agreements (CSAs) separate out funds generated from commissions, which can be set aside for buying research including from third-party providers. In continental Europe this practice is less well established.
Therefore, the move towards MiFID II’s research payment accounts (RPA), which demand strict separation between research fees and trading commissions, could have a bigger impact there.
However, the AMF consultation paper and its interpretation of the MiFID rules suggests that the new RPAs could very much resemble CSAs – albeit far more regulated than now.
The other point is that the AMF thinks that every EU member state should implement the rules on unbundling verbatim, that is with no bells and whistles. But given it is a directive and not a regulation, it is difficult to see how that will come about.
The UK is expected to gold-plate the rules regardless, by demanding extra procedures and safeguards from the industry. So while the UK is still in the EU, it could create an uneven playing field.
What do the bankers say?
The sell side is now resigned to this. Indeed, many investment banks and brokerages are responding by either specialising or by beefing up their research teams with big name analysts so they are competitive. One head of research recently remarked that it will be necessary to have analysts rated first or second in their specialities – anything lower and they could be out of a job.
Asset managers are not very happy, especially smaller ones, who could see a big hit to their bottom lines from paying for research. As such, the total spend on investment research across the industry is expected to drop.
Will it provide the incentive?
The big idea is that fund managers will buy top-notch research to improve their investment returns.
In that sense, the new rules should work. Because if fund managers have to pay for research from their own pockets, then they will have every incentive to shop around for the best they can afford.
Research providers, on the other hand, will need to create high-quality material tailored to investor needs. Analysts that develop stellar reputations for foresight are likely to be richly rewarded, while their more mediocre colleagues will fade away.
Whether this will change the fact that more than 75% of active fund managers underperform their respective benchmarks is yet to be seen. Nonetheless, it looks like a step in the right direction.
