The only thing constant in this world is change. And for the U.S. brokerage world, that axiom holds particularly true especially now in the face of looming regulation regarding payment for research.
Research, whether from a broker dealer or other source like a boutique research provider, is the genesis of any trade or portfolio strategy. Research generates the idea behind a trade and can mean the difference between generating alpha or just beta – preferably the former. Research drives the trading bus, plain and simple.
And up until now, the buy-side’s payment for research has come in several forms – commission sharing arrangements, client commission arrangements, “soft dollar” or “hard dollar” agreements, etc. But now that the Markets in Financial Directive II (MiFID II) is set to go into effect in Europe January 3, 2018, things are going to change as to how the buy-side is going to pay for its research from the sell-side across the Pond.
But its effects are not going to be limited to just Europe, traders and investment pros note, as trading is not limited by geographies any more. And now more than ever, North American regulation seems to be going in the same direction. MiFID II compliance will affect U.S. brokers as much as the European brokers the legislation is targeting.
MiFID II upends the traditional linkage between trading commissions and investment research in ways both the money management and brokerage industries have yet to fully understand, wrote Eric Noll, CEO at Convergex, in a recent paper. “It will force both the explicit pricing of sell-side research and the defense of those expenses to asset owners by money managers. Moreover, while this is an EU directive, we expect many global asset owners to eventually embrace its core principles of explicit pricing and transparency.”
In other words, US research providers and brokers need to take heed. MiFID II requires investment managers to rethink how they pay for brokerage firm research both abroad and here. No longer will they be able to bundle commission payments for trading execution and research services. Payments will need to outright in cash or via a Research Payment Account (RPA), to be funded either with an explicit fee charged to the investment firm’s clients or with commissions explicitly carved out of trading executions.
“While this is currently an EU-only mandate, how will it change both the creation and consumption of research in the U.S. and elsewhere,” Noll asks. “Once asset owners see the process start to take hold in Europe, they may well ask their managers in other markets for similar disclosures. MiFID II could well become a global standard for research pricing and disclosure, even if the actual payment mechanisms (commissions in the U.S., for example) remain unchanged.”
Allan Goldstein, COO of Trade Informatics, agreed that U.S. broker-dealers will not be insulated from MiFID II as many buy-side firms have a global reach and they will adopt a compliance standard adhering to the most restrictive regime.
“The concept of unbundling has percolated for years and the strict rules under Article 24 covering inducements are accelerating the trend globally,” Goldstein said. “So, the pinch is now coming from both sides – execution and research. Execution rates have been compressing or years but firms have survived by vying for the bundled research rates.”
But as Goldstein alludes, bundled research rates will also compress – and thus cull the herd of research providers – whether it be the brokers or boutiques.
“As those bundled rates become harder to come by, there will be a new round of attrition in the broker-dealer space as we saw in 2010 and 2011, when contracting execution rates and slashing broker lists forced out many high-profile agency shops,” he explained. “Survivors will have to streamline costs significantly and provide true value added services under SEC’s 28(e) safe harbor.”
The $10,000 Question…
Will MiFID II push the quality of research higher or lower?
It should push it higher, many believe. As the buy-side continues to face pressure to beat the market – either from its active managing counterparts or upstart passive managers, the need for quality alpha-generating ideas becomes very clear. And the brokers will either have to respond to that need or increasingly base their financial future on dwindling execution fees.
“Undoubtedly, we will see higher quality research being produced as consumers will vote with their feet, but the UK regulator is impatient for change,” explained Liquidnet’s Head of European Market Structure, Rebecca Healey. “The arrival of full unbundling will lead to a focus on excellence. Those brokers and other research providers who provide quality research will survive and even thrive in the new environment.”
Healey argues that strict MiFID II requirements for budgeting and the general unbundling trend creates downward pressure on pricing power for research providers and narrows the competitive landscape as some research providers won’t survive. However, the appetite and budget for research will still exist and the demand for quality will drive those remaining to deliver it.
“The regulatory regime will not impact the quality of research, it will simply reset the value proposition as has been done for execution services.”
It is clear from the latest Financial Conduct Authority (FCA) summary published March 3rd 2017, that the UK regulator believes the majority of UK firms are still falling short of expectations, and are failing to adequately assess and budget for substantive research that is of value to their end clients investments,” she added. The FCA highlighted the benefits of firms paying direct for research: the ability to mitigate conflicts of interest, provide greater transparency over the costs and charges to end clients and be fully incentivized to only purchase research that represents value for money. But this is not just a UK process, Healey warned. “MiFID II is designed to enhance research provision across Europe, not remove it entirely, and the global ramifications from an operational perspective are already becoming evident.”
So how does the 21st century post-MiFID II broker survive, yet alone, thrive?
The obvious answer would appear to be technology, according to many. Liquidnet’s Healey said that technology will enhance research provision – and research selection. The introduction of metadata in both the provision and selection process will enable firms to hone in on the research they need.
“As buy side firms move to greater control of the research process, more internal analysis will be created, but it will be those firms that can leverage new external sources of data from multiple streams who will gain from the information advantage,” she said.
Mark Holmes, CEO of Waymark Tech, said that many smaller buy-side firms will be forced to adopt new technology over the next 12 months to survive rapid regulatory change brought about by MiFID II, UCITS and AIFMD.
“These changes will disproportionally affect smaller buy-side firms, whose compliance teams are already overstretched,” Holmes added. “The new MiFID II research payments regime will be particularly testing, and will put many compliance teams under strain earlier than they expect.”
Trade Informatics’ Goldstein added that the electronification of trading equities has certainly already had an impact on trading desks and personnel and that artificial intelligence (AI) represents the next generation of systematic trading and will continue the trend.
“And while sellside desks have shrunk as a result, the traders that remain have had to remake themselves as ‘electronic sales traders’ which entails anything from functioning in a support role, monitoring the health of low touch and no touch trade flows to quant traders analyzing optimal trade flows, consulting with clients on market microstructure or helping to construct customizations to algorithms,” Goldstein said. “So traders are adapting and re-training or fading away. However, the larger question is how do brokers remain relevant to stay on the broker list so that the traders who do survive have flows to monitor and optimize? The value add proposition has never been more challenging and brokers must show that they have substantial capabilities to provide relevant research and accretive execution services such as liquidity provision in small caps and highly sophisticated alpha optimization strategies.”
Waymark Tech’s Holmes concluded that regtech firms will not only find a role in helping smaller companies drive efficiencies and automate regulatory processes, “but in providing compliance departments with personalized information about regulatory changes and compliance cycles too.”
You’re Still the One
At the end of the day, while MiFID II presents yet another tremendous change in equity market structure, it will be endured and adjusted to – much like decimalization, electronification and fragmentation. And the brokers, research sales traders and equity analysts will all still be an integral part of the market landscape. No amount of AI, regtech or technology can replace the gut feeling or random hunch a human will have when it comes to producing and/or distributing an alpha generating idea.
“It is undeniable that the buyside is owning more and more of the responsibilities associated with services traditionally outsourced to the sellside. The buyside’s adoption of trading technology is prevalent, and while portfolio modeling is growing in sophistication, the U.S. based buyside continues to have a healthy appetite for sellside research and the use of client funds to pay for it,” said Goldstein.
“Sellside research has long been used to supplement in house research and this will continue for the foreseeable future.”
Mike Stepanovich, CEO of Visible Alpha’s ONEaccess business said that ever since Regulation FD and the Global Analysts Research Settlement in 2003, brokers have had to compete on the value of their research, insight and services.
“We already live in a world where only the best research providers and offerings survive,” Stepanovich said. “However, in a MiFID II world, we expect even more scrutiny on research spending from the buy side. To remain competitive, research providers will need a better understanding for how their services are being consumed and valued.”
What's next up for the SEC market structure committee?