MiFID II set out to improve on its predecessor by upping investor protection and making it easier for regulators to keep tabs on trading in Europe. One year on it has become clearer where some of the chips will fall. Meanwhile, the market has its hands full with some of the short-term fallout, writes Kat Van Hoof.

Europe flag

The biggest single piece of legislationEuropean capital markets have ever had to process, the second Markets in Financial Instruments Directive (MiFID II), came into force on January 3, 2018. MiFID II expands on the first iteration, which was implemented on the eve of the financial crisis in 2007, and contains more than 1.7 million paragraphs, touching every part of the trading value chain in Europe.

Such a vast piece of regulation will have side-effects, and most of the concerns from the sell side focus around curtailing competition and restricting access to capital markets, particularly for small and medium-sized enterprises (SMEs). One year on, firms on all sides are still adjusting. Significant regulatory change always takes a while to bed down in operational models and trading structures, says Michael Thomas, a partner in the financial services team at law firm Hogan Lovells.

Implementation has been costly and time consuming, but has it been effective? It is difficult to distil MiFID II to a concise set of objectives, but there are two recurring themes in its quest for greater investor protection: transparency; and harmonisation of European markets. Just over 12 months in, it seems that much still needs to be ironed out.

Harmonising discord

Forcing 27 EU member states, whose markets have evolved independently and have different national regulators, into a one-size-fits-all regime is no mean feat. MiFID II aims to bring the diverse and fragmented European capital markets closer to the gold standard of the US model, which operates under a unified regulatory regime.

“What came into force in Europe was a mix of regulation, which applies directly, and a directive, which is transposed at a national level, complemented by several implementing regulations,” says Pedro Pinto, director for advocacy at the Association for Financial Markets in Europe (AFME). Immediately, this creates discrepancies at a national level, a far cry from the desired harmonised approach. 

Mr Thomas agrees, saying: “Domestic regimes don’t always conform neatly with the rules set out in the directive, some of the definitions and terms are nebulous and open to interpretation.” He suggests the question is: “Do we change the market to meet the straightjacket regulatory requirements, or do we interpret the regulatory requirements differently to fit the market?” The former could be destructive for local markets, but the latter negates the potential to achieve meaningful policy change.

If the push for harmonisation is to be successful, it requires collaboration between national regulators and European authorities. AFME is all for a greater supervisory convergence role for the European Securities and Markets Authority (ESMA), “provided the industry is consulted and allowed input on ESMA’s supervisory convergence rule in a transparent way”, says Mr Pinto. ESMA already provides guidance, but the industry is seeking more of a two-way street. Before MiFID II went live, ESMA ran some consultations, but critics claim they did not sufficiently address industry concerns.

Transparency trap

It is clear that MiFID II has led to greater availability of data, but that is not the same thing as greater transparency, according to a senior banker at a top five European investment bank. The reporting burden for all participants has ramped up exponentially, creating a data deluge. “Picking cogent signals from the noise is very difficult,” says Julian Allen-Ellis, director of MiFID at AFME.

Ironically, the reporting burden could be increasing corporates’ dependencies on banks, which is diametrically opposed to the spirit of MiFID II, according to Mr Thomas. “Companies are more reliant on banks to comply with reporting standards, as smaller businesses don’t have the bandwidth themselves and bigger companies with strong existing relationships are only too happy to delegate these tasks,” he says.

Questions have also been raised about whether the data is being put to good use. Distributed ledger technology could be helpful in providing the desired level of access to the regulators at a much lower cost, according to Mr Thomas. “Unfortunately, MiFID II is not sensitive to this at all and reporting needs to be done via an approved reporting system with specific regulatory authorisation,” he says.

ESMA recently put out a call for evidence on the effects of MiFID II, which is “emblematic of where regulators are one year in”, according to Philippe Guillot, executive director of the markets directorate at the French national regulator Autorité des marchés financiers (AMF). Data quality is of the utmost importance in order to engage in evidence-based policy and make any meaningful assessments of MiFID II’s impact, says Mr Pinto.

Chicken and egg

There is an argument that the financial industry was already changing rapidly, and that the MiFID edicts are but two of many drivers of this transformation. Prior to MiFID II, the investment management services industry was already becoming more cautious about which benefits are acceptable and what should be paid for, according to Mr Thomas.

Moving more trading to electronic platforms and away from hard-to-monitor phone conversations slots in with a shift to algorithmic trading. “The shape of the asset management industry has changed from the mid-2000s onwards with the huge rise in passive investments,” says Mr Guillot.

This is a chicken-and-egg question to a certain extent, according to one senior banker at a major European investment bank. He asks: did it all begin with MiFID, or did MiFID simply accelerate a process already in motion?

At least in the short term, the doomsday predictions of market collapse from MiFID II proved to be false. “It is clear that there was no major disruption to the market on implementation and that the worst fears about liquidity drying up and market structures failing were unfounded,” says Mr Guillot. The market made a tremendous effort to be ready on time for as smooth a transition as possible. “The MiFID II go-live was not viewed as a true ‘big bang’ event but rather as a significant milestone in a long, complex, phased implementation process,” says AFME’s Mr Allen-Ellis.

Winners and losers

Over the past 25 years, starting well before either directive, the balance of power between sell side and buy side has been tipping towards the latter, according to Steven Fine, CEO of UK broker Peel Hunt. “It feels like MiFID II was the peak of that power shift, due to the massive price war and race to the bottom on equity research pricing,” he says. MiFID II has forced banks and brokers to separate out fees for research and execution. The buy side almost uniformly decided to absorb the price of research, rather than pass on the charge to clients, but slashed budgets dramatically.

“The level of pricing for research is far below expectations,” says Andrea Vismara, CEO at Italian independent investment bank Equita. This is largely due to the aggressive undercutting of pricing by the biggest banks, mainly from the US, he adds, saying: “These banks can subsidise the cost of research with their activities and trading flows outside Europe.”

Mr Fine expects the potential for some pricing pressure to return in a year or so because asset managers will be prepared to pay for high-quality research. Mr Vismara is less optimistic, believing the big US firms could well sustain rock-bottom pricing. In response, the UK Financial Conduct Authority in mid-2018 announced a review of pricing of research packages, which could be in breach of MiFID II’s inducement rules.

In the meantime, smaller and independent brokers have been the biggest losers: UK stockbroker Cenkos reported a 90% drop in profits and Numis warned investors about full-year profits in late 2018. There has been much talk of consolidation at this end of the market, particularly among brokers servicing SMEs and micro-caps. Some consolidation at the smaller to micro-cap end of the fragmented UK brokerage market is not necessarily a bad thing, but the barriers to entry for new brokers in the small and mid-cap space have skyrocketed, according to Mr Fine.

Independent brokers are much thinner on the ground in continental Europe. “MiFID II is indirectly causing concentration in the market as investors flock to incumbents, but gaining market share has not increased revenues in the new environment,” says Mr Vismara. He speaks from experience: Equita has long been the dominant research house in Italy, a position that has only strengthened over 2018. “It may benefit us in the short term, but what good is that if it is bad for the industry in the long term?” he asks.

Access under fire

Many analysts have been laid off, while those who remain are looking after an increasing number of stocks. “An obvious casualty of these changes is the quality of research if analysts can no longer spend as much time on individual stocks,” says Mr Fine.

In February 2019, Peel Hunt released the results of a survey of 102 UK-based fund managers and 105 listed SMEs. Two-thirds of the surveyed investors said that less research is being produced on SMEs. Of the companies, 25% said that MiFID II has had a negative impact on their business and 41% said it had negatively affected the liquidity of SME stocks. It should be added that 2018 was not a good year for equities in general.

“Before MiFID II, firms tended to use fees from blue-chip coverage to fund research on SMEs, but this link has been cut. It raises questions about what happens to the quantity and quality of this type of research,” says Marianne Jarlaud, senior policy officer at the AMF. “The coverage of SMEs is clearly one of our main concerns.”

Initial figures seem to confirm the AMF’s fears, but it intends to gather more data. “Assessing the impact will take time and it will be difficult to say whether it is due to MiFID II or whether it was happening anyway,” says Ms Jarlaud. The data points to a correlation, but it is unclear whether there is causality, agrees Mr Pinto.

It makes sense that most banks and brokers are turning their eyes to the big stocks, as these are traded more often between the biggest investors, so there is greater demand for blue-chip research. The rise of passive management had already resulted in fewer small to mid-sized companies being covered, so they tended to be covered by small, local brokers, which are thinning out, according to Mr Vismara.

If there is little analyst coverage, there is a concern that access to capital markets for these SMEs will be more restricted. Not only will they be on fewer investors’ radars, big banks may be less likely to underwrite capital increases for smaller businesses if they do not have a relationship with potential shareholders in this segment to offload shares to, according to Mr Fine. This is a complex issue, of which MiFID II is only one factor, according to Ms Jarlaud; barriers to accessing capital markets is a topic that goes back a long way.

MiFID III?

Regulators have not stood still since January 3, 2018; several reviews and consultations are under way in France, Germany and the UK. In order to restore some balance to research on SMEs, Equita’s Mr Vismara proposes active measures to promote this service, such as “tax benefits or credits for brokers following SMEs or favouring these brokers from a regulatory standpoint”. However, this raises the question of how far any regulator should go towards propping up parts of the market.

One senior European investment banker says the MiFID II debate comes down to narrowing margins in investment banking, but counters that he has yet to see an industry that is more resourceful in reinventing itself when necessary. Mr Fine agrees that MiFID II is offering “one of the greatest opportunities in a generation to materially grow a high-quality corporate client base – if you have the buy side on your side”.

Mr Pinto concludes: “Regulatory change with limited data evidence in support doesn’t always turn out to be beneficial for the market and investors, but that is something for MiFID III to sort out.” 

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