MIFID 2 and research: a script to be reworked
The implementation of MiFID 2's requirements on research has induced a sharp reduction in the coverage of European SMEs. The financial industry is now asking whether the regulation should be amended.
Even before they were implemented, at the start of 2018, the MiFID 2 provisions on financial research caused major concerns among both sell-side firms and issuers. Firstly, these measures had not been really discussed by the European co-legislators, and did not appear until the implementation texts were drawn up, under the sole influence of the UK’s Financial Conduct Authority (FCA). Secondly, and above all, the general requirement to unbundle order execution fees and payments for research led to fears that research's already fragile economic balance would be destroyed, along with the risk of an erosion of coverage, particularly for SMEs.
Almost two years after the entry into force of MiFID 2, and despite a few small concessions obtained by the industry, market developments seem to confirm that the fears expressed were indeed well-founded.
At the European level, given the weight of the restrictions imposed on firms if they wish to continue passing research costs onto investors, the large majority of asset managers have chosen to pay for the research they use out of their own funds. Furthermore, while the new rules only applied to portfolio management, almost all managers have extended them to the management of collective investment schemes. The coexistence of the two different models for paying for research would indeed have given rise to issues that are difficult to overcome. In a context of fierce competition and threats to their own margins, this change in model has obviously driven them to reducing the associated costs. Their approach has received unexpected support from certain large investment banks, which are major producers of research, and which have offered extremely low rates for their research, seeing this as an opportunity to increase their market share in Europe.
It is currently difficult to estimate the impact of these movements on the budgets allocated to financing research, especially as they were sometimes not clearly defined before the introduction of MiFID 2 reforms. However, while some studies carried out among management companies only report limited falls, most research suppliers indicate that they have seen their remuneration fall significantly since 2018, often in proportions of around 40%1.
The business plans of research suppliers reworked
For research suppliers, the reform led to a more in-depth reflection on the value of financial analysis, and the adoption of new pricing models. These models are more often than not based on different packages, ranging from the simple dissemination of written notes to clients being able to interact with analysts. Furthermore, beyond the equity universe, the pricing of research has been extended to credit, index and strategy research, in particular, but at levels that are much too low to generate significant revenues.
In this context, what is the effect on the coverage of European companies?
The question needs to be answered as the existence of financial analysis has a direct effect on issuers’ financing costs2, and as the ecosystem of the supply of research has shown significant weaknesses for a long time, notably for Small and Medium-sized Enterprises (SMEs) and “Intermediate-sized” companies (ETIs). In this respect, several points of weakness have been documented by AMAFI3: research on SMEs and ETIs is produced by just a few domestic companies (in France, three companies account for 40% of the research produced), which by their nature are very sensitive to local economic conditions, and the market has historically been renewed through the creation of new players, which the unfavourable conditions created by MiFID now seem to make virtually impossible.
Overall, although it is probably too early to form a definitive picture, several indices now suggest a fall in the supply of research in Europe, with a significant impact on the coverage of SMEs and ETIs. An academic report4 published this summer indicates that over 300 European companies have lost all sell-side coverage, and the reassuring analysis recently produced by the FCA attracted harsh criticism from market players5. In France, the concerns are strong enough to have led the financial industry to reunite around the MiFID Vision6 initiative, and in July 2019 the AMF launched an initiative aimed at exploring ways of improving the research situation7.
What are the solutions?
Several solutions certainly deserve consideration in order to prevent further damage to the financial analysis ecosystem.
Firstly, the introduction of a form of proportionality into the MiFID II provisions should be considered, which would exempt the smallest firms and research on SMEs and ETIs;
Secondly, provided that any resulting conflicts of interest can be sufficiently contained, the developments to research sponsored by issuers must be supported, to restore a viable economic model for suppliers.
More generally, the experience of the impact of MiFID 2 on research should be a serious warning for the European co-legislators: in order to avoid this type of counter-productive effect, the process of developing regulations must endeavour to better anticipate their effects, and must seriously examine their impact on the competitiveness of the European financial industry.
1The report issued in September by the FCA mentions a fall by 20% to 30% of budgets set by firms to spend on research, with an impact probably concentrated on a majority of providers.
2 See, for example, the report by the Observatoire du Financement des Entreprises par le Marché.
4 Bingxu Fang, Ole-Kritian Hope, Zhongwei Huand and Rucsandra Moldovan, The effects of MiFID II on sell-side analysts, buy-side analysts and firms.
5 See the review published by the FCA, and the subsequent reactions (FT: FCA attacked by research houses over Mifid II reforms).
6MiFID Vision, steered by the SFAF, which the professional buy-side and sell-side associations, as well as the AMF and Bpifrance, have joined.