Brexit is the least of the financial service sector’s worries

August 25, 2017

Amid all the talk of Brexit and its implications for UK financial services a more significant issue is rapidly approaching in the form of an acronym called MIFID 2. MIFID stands for Markets in Financial Instruments Directive – it is a wide ranging piece of EU legislation designed to boost investor protection, increase transparency and improved market structure across a range of financial markets. It comes into force in just over four months’ time on 3rd January 2018. But this is not a piece of interfering European legislation dreamt up in Brussels and imposed upon a reluctant UK industry. In fact it is the UK regulator, in the form of the Financial Conduct Authority, which is behind a large share of the MIFID rules.  MIFID 2 will have far reaching consequences both for financial market practitioners and ultimately investors – i.e. anyone with a pension, equity ISA or similar investment.

Costs eat into investment returns

One area where fundamental change will occur is in the market for financial research. Research is vital in determining the correct price for financial assets – the so-called price discovery process. This is crucial in the formation and allocation of capital in a market economy. The costs of research – along with other costs – are ultimately borne by investors. Those costs have become increasingly apparent as regulators have required the impact of costs on total returns to be made explicit in account statements and other investor communications.  These disclosures reveal how costs can dramatically eat into total returns on investments, especially those held for several years.

Research needs reform

But research costs have been far from explicit. Historically research costs have been wrapped up and included with trading commissions. So an asset manager would pay commission to a broker for executing transactions in securities: bundled in with the commission payment would be the costs of research provided by the broker to the asset manager. But there would be no explicit charge identified for the research component (or for execution of trades).  The result is that too much broker research is produced partly as an inducement to trade and brokers could avoid delivering either best execution or quality research.

The new MIFID rules will require complete unbundling of research costs. Asset managers have two choices (i) pay for research out of their own resources, the P&L approach or (ii) a so-called transactional approach where the costs of research can still be taken out of commissions but the research element must be made explicit and research costs must in no way be related to the volume of business.  Asset managers will have to show due diligence on research providers and demonstrate that the research is relevant and represents good value – in effect they will have to demonstrate that they are buying research “as if” from their own resources.  The costs of compliance with this second option are likely to be significant.

Less research – but of higher average quality is likely outcome  

The basic point is that the costs of research will be made explicit and that this will result in a more efficient allocation of resources. Under bundling “too much” research was produced by brokers – some of which was maintenance in nature and of little value, some original and of high quality. (Having worked at a broker I can testify to this!)  The regulations should put independent research on a level playing field with independent research companies which have always had to charge explicitly for research (since that is their sole offering). But overall resources in financial research will almost certainly be reduced. Already there have been reports of some of the big brokers estimating their research to be worth say £x a year and the asset managers buying said research valuing it closer to, say, £x/4. Depending on where the bargain is eventually struck there may well be “restructuring” i.e. swingeing cuts in research, especially in the major banks.

What could possibly go wrong?

The basic principle of the regulation is sound – separate pricing and charging for research, the creation of a level playing field among research providers etc. In addition, a reduction in costs may ultimately boost investor confidence and help to increase investment flows. But of course there is always the law of unintended consequences. One concern is that there may be too little research done, notably research on smaller companies. Hitherto there may have been an element of cross-subsidisation from research on large companies to smaller companies research. But a dearth of research on small companies could inhibit the market process by effectively increasing the cost of capital to smaller companies.

Financial services have always been subject to heavy regulation given the information asymmetries, conflicts of interest and lack of transparency associated with the industry. Against this it must be remembered that regulation is costly and compliance costs can act as a barrier to entry and restrict competition. In theory MIFID 2 should improve the functioning of financial markets by revealing the true cost of research so that only research of value is produced – as opposed to research that might boost trading commissions.  But business models, revenue streams and market structure are all likely to change over time in ways that cannot be predicted.

MIFID rules to have global impact   

Note that Brexit will not have any material impact on MIFID 2 since it will come into force over a year before the UK is due to leave the EU in March 2019. Even if this was not the case the rules would still apply in the UK as they are generally supported by the FCA.  Moreover, the reach of MIFID 2 looks like it will extend beyond Europe; many US firms have indicated that they will adopt MIFID 2 rules in order to avoid multiple compliance regimes. Compared with MIFID 2 the effect of Brexit on UK financial services is likely to be rather modest.

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