MiFID II – Research Unbundling

With such a diverse interpretation of Research unbundling across the industry, how long will the regulator wait before attempting to standardise their approach?

Alex Cartoon

As the dust settles after MiFID II go-live on the 3rd January 2018, the industry is still in the dark as to how the regulator wants research unbundling to be interpreted. Approaches from the sell-side are fragmented with little consistency. Buy-side clients are in some cases are paying different prices for the same piece of research.

The interpretation has been diverse with a wide range of pricing models and charging structures. Table 1 gives an illustration to just how diverse this charging has been between some of the large sell-side banks, prices ranging from $10,000 up to £350,000.

The FCA has commented on the fragmented approach in the industry and is keeping a close eye on the impact of forcing asset managers to pay separately for research from other broker services. Andrew Bailey, chief executive of the FCA (Financial Conduct Authority) was quoted as saying “The reform had an effect on the market for research and the market is still adjusting as the price discovery unfolds. We are going to keep this under very close scrutiny”.

So, what exactly have the changes been and why is the industry adopting such different interpretations when trying to implement research unbundling? Transparency and clamping down on inducements has been a key focus for the ESMA and the FCA. This extends to research because the regulator views ‘free’ research as an inducement to trade. Research was previously seen as a non-for-profit activity which supported the over-all selling strategy of a sell-side firm. The changes mean that unless research in made ‘publicly available’ and free to all (one would question the value of it in such a case) then the asset manager is required to either pay for it or is not entitled to receive the research. Diagram 1 illustrates the change from how a sell-side research department must now be compensated.

ESMA has suggested that asset managers should have a RPA (research payment account). This can effectively be a pot funded by Profit from the asset manager which they can then use to spend on research. This has enhanced controls and would replace the previous CSA (Commission sharing agreements) which tended to be discretionary without any monitoring. Asset managers will be expected to produce research budgets and justify their spend.

The challenge comes when trying to price what research is worth as this task is extremely subjective. Asset managers clearly need to be able to justify their investment decisions to their investors and need a certain amount of research is required. The question on how much they are willing to pay for it and should they pay for certain parts only. This has led to four main pricing models *Source: Vicky Sanders RSRCHXchange (no doubt there are others and variations):

A platform only solution – Users pay a subscription fee to access.

Rate Card model – Fee agreed with an incremental fee agreed upfront; total payment determined by usage

Variable advisory model – Large fee for full service and Top-up fee depending on usage

Vote model – Nominal fee paid upfront. Voting by asset manager to determine the pieces of research they found most valuable in making investment decisions.

Trying to implement a model even when you have decided which one to use has proved to be a challenge. Client data needs to be brought up to scratch to be able to identify who clients are particularly when they are classified by LEIs (legal entity identifiers) and an Asset Managers fund could have many sub-funds, each with its own individual LEI. Luckily ‘trial-periods’ have afforded Banks some grace period to ensure their models are operational, however once this trial has been taken up in one entity in a group it cannot be extended to a different entity.

Diagram 1 – Model A) shows the previous pre-MiFID II arrangement for sell-side research departments. Model B) shows post-MiFID II research now needs to be paid for by the asset manager, separately from Execution costs.

One of the large grey areas was around whether research can be accepted for free, for example in the case of a trial. ESMA has now clarified this point in their July level 3 Q&A stating that whilst based on article 12(2) of MiFID II delegated directive investment firms should not accept non-monetary benefits, a free trial would qualify as a minor non-monetary benefit provided certain conditions are met. (For example, entering into a contract to say the services are billable and that the trial lasts no longer than 3 months).

This big shakeup in the research industry which is supposed to make the market more of a level playing field has had some unintended consequences and the playing field may take a long time to become anything near level. The turbulence risks a ‘race to the bottom’ where sell-side firms may offer predatory pricing (since there are no guide-lines on what to charge) to gain market share and then raise prices once competitors are put out of business.

Whilst this may be considered a big threat for the smaller IRPs (Independent research providers) they have already been competing against free research for many years and manage to survive because they offer specialised well written research. They are also nimble and can focus on new sectors / asset classes (crypto-currencies).

The regulation has clearly had a big effect in the industry and led to several job losses in sell-side research, as banks try to justify their research departments and turn them into a profit-centres. This has undoubtedly benefitted the IRPs and led to more specialist research being created benefitting technical research analysts. Technical research has typically been quite niche in sell-side banks and perhaps with this industry change the balance between technical vs fundamental/economic research pieces may be addressed to some extent.

Clive Lambert from FuturesTechs comments that “MiFiD II was “in theory” going to be a good thing for independent providers, but with the “predatory pricing” Tom mentioned it’s not been an easy start, and I for one still often hear “we get free research” from prospective clients, which is all rather frustrating. IRPs have an opportunity to flourish, but only once it becomes generally accepted that research is something that needs to be budgeted for and paid for, much like data is now. Unfortunately, six months on from MiFiD II this hasn’t really happened yet”.

The STA (Society of Technical Analysts), a not-for-profit organisation which teaches and promotes technical analysis and research held a MiFID II research panel last year on 14th November 2017, shortly before the go-live for the regulation. What was clear from the speakers was that despite this representing a major upheaval in the industry it did present an opportunity to IRPs and for the industry to offer more specialised research to asset managers. The overall quality of research should in time go up as Asset managers will not pay for bad research. Whilst it has meant a lot of upheaval in the industry, companies who differentiate themselves by writing quality research will prevail.

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