Seeing the impact of European regulation

By Alistair Jones

SMU Office of Research & Tech Transfer – Regulation has never been a popularity contest. By definition it will impose limits and exercise controls. Its rules can prove beneficial to some more than others and, as likely as not, there will be unintended consequences.

Designing a unified regulatory framework to improve the function of the financial services industry across the diverse countries of the European Economic Area – which comprises the 28 European Union (EU) members plus Iceland, Liechtenstein and Norway – was a complex challenge.

Such is the scale of the Markets in Financial Instruments Directive II (MiFID II) which came into effect on January 3, 2018 – six years after the European Commission adopted a legislative proposal for it. And while reaction to how it works in practice has been mixed, it did set out with good intentions.

“MiFID II was implemented with the goal of making the capital market more efficient, transparent and investor-friendly,” says Bingxu Fang, an Assistant Professor of Accounting at Singapore Management University (SMU).

MiFID II is a revised version of the original MiFID, which was implemented in November 2007. When the global financial crisis hit, weaknesses in MiFID's provisions became apparent, such as its focus on stocks to the exclusion of other assets and income vehicles, and it did not cover dealings with firms or products outside the EU.

“Compared with MiFID, MiFID II introduced a wide range of new regulations across several categories, such as market structure, investor protection, transaction reporting and transparency,” Professor Fang says.

Sell-side and buy-side

“MiFID II introduced restrictions to the common practice of inducements in the sell-side research industry and it was expected to have a fundamental impact on the industry’s business model,” Professor Fang says.

An examination of how MiFID II has changed the provision of sell-side and buy-side analysis – and what this has meant for the industry – is the thrust of new research co-authored by Professor Fang.

Sell-side analysts typically work for a brokerage and make recommendations to clients of the firm, such as institutional funds, to convince them to trade through the firm.

They may also make 'blanket' recommendations directed at the general mass of the firm's clients rather than one in particular. Sell-side research has sometimes been seen as akin to marketing for the firm.

A buy-side analyst typically works for an institutional investor and determines how promising an investment seems and how well it coincides with their fund's strategy. Their recommendations are made exclusively for the fund that employs them.

An important change under MiFID II is the requirement for asset managers and broker-dealers to unbundle the cost of investment research and advisory services from the cost of trade execution.

In other words, the information presented to the client must separately and transparently show all the different costs and charges, including any third-party payments, as well as justify how external research contributes to better investment decisions.

Information environment

The unbundling requirements of MiFID II have had the effect of decreasing the amount of sell-side analysis and causing the remaining work to be more targeted.

“We found that the quantity of sell-side research became less, while the quality of research improved,” Professor Fang says.

But is there a net gain in having better quality sell-side research if there is much less of it and its information is not widely available?

“We examined the change in covered firms’ liquidity to evaluate the net effect of MiFID II on firms’ information environment. Our results suggest that the net effect is on the negative side,” Professor Fang says.

As jobs have shrunk on the sell-side, other opportunities have opened up on the buy-side, with more in-house teams which now have an active involvement in earnings conference calls. The changing dynamic has shifted some of the costs of equity research to the buy-side.

“That is consistent with our empirical findings and survey evidence from the industry. Asset managers are conducting more research through their in-house teams and reducing their payments to the sell-side,” Professor Fang says.

And what of the MiFID II requirement to justify how external research contributes to better investment decisions?

“It is costly and complicated for investment managers to justify any research costs passed on to investors, especially for large asset managers. Therefore, according to survey evidence from the industry, most European asset managers have decided to absorb the costs directly,” Professor Fang says.

Burdensome regime

One criticism of MiFID II is that it stipulates the management of significantly more data, adding new pressure to IT systems and administrative resources. For example, 50 more fields need to be completed for transaction reporting alone.

“I believe regulations are an on-going process, and the comments and feedback from the market participants are essential for regulators to modify the rules,” Professor Fang says.

“In fact, the European Securities and Markets Authority (ESMA) has acknowledged that the existing regime is burdensome and has proposed changes to streamline the reporting requirements.”

As an information intermediary, sell-side research has acted as a public signal. But the advent of fewer sell-side analysts has seen a concentration on covering the firms that are most important to the sell-side, which are the bigger clients. Some small and mid-sized firms have raised concerns about their capacity to pay for research and even to remain in business.

“I think the impression from the industry is that MiFID II generally favours the big players because they have more resources and have the potential to dominate the market for research,” Professor Fang says.

“One of the main findings in our paper is that there are companies that lost all of their coverage after MiFID II, especially small companies. The loss of coverage may have a significant impact on the firm’s information environment and make it hard to reach investors.”

And is MiFID II likely to become a global standard?

“Regulators across the world have been monitoring and evaluating the effects of the regulation, and I believe it will take time before other countries decide to adopt similar policies, especially when ESMA is considering whether to modify the rules under MiFID II,” Professor Fang says.

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