Our Insights

Finding value in MiFID II's unbundling directive

Scrutiny may do little to impede global adoption

Concerns about the impact of unbundled research and brokerage charges under the second Markets in Financial Instruments Directive (MiFID II) have prompted reviews by European regulators, yet are unlikely to halt the regime’s global adoption.

Key insights

  • Under MiFID II, asset managers have shown willingness to absorb costs of research but have grown more judicious about spending
  • Concerns about the market impacts of MiFID II are unlikely to see unbundling rolled back
  • The US is under pressure to adopt unbundling as global asset managers voice concerns about costs of double billing

Proponents for change are many. Global asset managers must juggle conflicting payment rules outside of Europe, and cost-conscious pension funds are putting pressure on regulators in the United States (US) to put an end to the opaque pricing of bundled research.

MiFID II’s market shake-up has squeezed small brokers

The unbundling reform was intended to increase transparency in capital markets and boost investor protection yet the new regime has come as a reality check for the research industry. Buy-side clients have become more reluctant to pay for coverage that was once provided free with brokerage, causing the price of research to plummet. While investors have welcomed the availability of less expensive research the price plunge has squeezed margins, placing small brokers under pressure and raising concerns of a decline in coverage for small and medium-sized firms.

Asset managers are absorbing the costs of research

Some 18 months on from the unbundling requirement, Europe’s investment banks are concerned that unbundling is adding more strain on a sector that is already struggling to absorb declining management fees and brokerage due to the rapid rise in passive investing. With asset managers under pressure to reduce fees, most have chosen to absorb the costs of research rather than pass them on to clients.1 The consequence has been a reduction in research budgets as fund managers look to ease pressure on margins. Euro IRP, the trade body for independent research providers, has estimated that asset managers’ research spending has reduced by an average of 30 percent since MiFID II came into effect in January 2018.2 The contraction of the market has seen brokers cut research on small and medium-cap firms. The average number of analysts covering each stock in Germany’s main small-cap index fell to 8.5 in December 2018, from over 9 a year earlier, with a significant reduction also reported in the United Kingdom’s (UK) FTSE small-cap index.3

While investors
have welcomed the
availability of less
expensive research
the price plunge
has squeezed

Shrinking coverage has raised fears that small-caps may lose profile among institutional investors, suffer lower liquidity, and face difficulties tapping the markets for credit. “The wider consequences are by now abundantly clear to everybody. Less coverage of smaller caps, fewer brokers focused on anything other than the very large listed companies, and consequently weaker interest from institutional investors in the companies that represent the backbone of the European economy,” said Andrea Vismara, CEO of Italian investment bank Equita.4

The effects of unbundling have also fanned concerns about the quality of research. A study by Italian regulators into the effects of MiFID II found more providers were funnelling resources into computer-based and algorithmic-driven research, rather than traditional research based on fundamental analysis.5 “I believe we should try to strike a better balance between the importance of a transparent pricing system that prevents conflicts of interest, and good investment processes that are fuelled by deep investment coverage,” said Carmine di Noia, a commissioner at Consob, the Italian regulator.6

Multiple European Union (EU) regulators are reviewing unbundling’s impact

Other EU regulators have raised concerns. Robert Ophele, Chairman of the French markets watchdog Autorité des Marchés Financiers, called for a review of unbundling in part due to its “very detrimental” effects on coverage, particularly for mid-cap companies.7 Germany is also reviewing MiFID II’s impact a year after its implementation, having launched a consultation period with industry participants that ended in March 2019. The UK’s Financial Conduct Authority (FCA), which launched a review in 2018, gave unbundling a mixed assessment in February 2019, saying it had cut costs for investors but also given rise to competition concerns.8 The FCA’s CEO, Andrew Bailey, reported that research fees incurred by investors in equity portfolios managed in the UK were about GBP 180 million lower in 2018 than the previous year.

The effects of
unbundling have
fanned concerns
about the quality
of research

Investors could stand to save approximately GBP 1 billion over the next five years, according to the FCA, which also noted that small research providers were being unfairly impacted by below-cost research offered by larger sell-side firms with more market power. “This is something we are keen to scrutinize and test, especially low-cost ‘all you can eat’ packages, or one-off events such as conferences priced substantially below cost,” Bailey said.9

Unbundling. The global standard?

Such scrutiny is unlikely to see the unbundling rule rolled back. However, advocates of the reform point to the willingness of asset managers to take on the fees themselves rather than pass them on to clients, which would meet one of the principal aims of MiFID II—reducing investor costs.

“The regulation has reached its objective in the sense that asset managers need to make sure that if they pay for research, it has value,” said David Petiteville, Director, Regulatory Solutions at RBC Investor & Treasury Services. “With asset managers taking on these costs, the regulation has had that intended effect.”

Investment managers have also shown a preference to pay for research in non-EU markets rather than confine the unbundling to Europe. Large fund managers, particularly, are growing weary of the administrative burdens of maintaining multiple payment systems. Moreover, being globally MiFID II-compliant may also be seen as a competitive advantage to attract clients.10

The regulation has reached its objective in the sense that asset managers need to make sure that if they pay for research, it has value

The US has so far resisted unbundling but MiFID II has put pressure on global regulators to move to adopt this approach. Regulators may now be more open to ending the current “soft dollars” arrangement in which research is bundled by brokers. Although the Securities Exchange Commission (SEC) issued a no-action relief in October, 2017 that allowed US fund managers affected by MiFID II to continue to receive bundled research, the relief expires in 2020, and SEC officials have made no indication they intend to extend it.11

Large pension funds that invest through asset managers are also questioning whether investors are getting value for money through bundled arrangements.12 Brokers, meanwhile, have countered that receiving payments for research alone might see them fall offside of US regulations as they are not registered as “investment advisors”.13

Nonetheless, the momentum behind the global adoption of MiFID II may ultimately override those arguments and prove too strong for the SEC to ignore.

“I do believe there is pressure from the US market to land on a single approach because right now it can be difficult to manage across markets. In one market, research may be bundled into brokerage, and in another it may be unbundled with separate fees applied,” said Petiteville.

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  1. Financial Times (May 7, 2019) Where now for the rules that rocked European finance?
  2. Ibid.
  3. Reuters (January 2, 2019) One year after MiFID II, European stocks coverage falls
  4. Financial Times (May 13, 2019) Why Mifid II is a menace to investment banking in Europe
  5. Financial Times (May 7, 2019) Where now for the rules that rocked European finance?
  6. Ibid.
  7. Reuters (January 2, 2019) Pressure on small brokers grows a year after new EU rules
  8. Pensions and Investments (February 25, 2019) Investors pay less in research fees in 2018
  9. Ibid.
  10. The Economist (January 5, 2019) The EU's unbundling directive is reinforcing the power of scale
  11. Bloomberg (January 23, 2019) Wall Street braces for MiFID-style rules descending on the U.S.
  12. Ibid.
  13. Ibid.