“If we knew what we were doing, it wouldn’t be called Research” Albert Einstein
The market for investment research is on track for cataclysmic change in less than 342 days. The MiFID II rules on inducements are the latest in a long running series of regulator attempts aimed at strengthening the framework for inducements to ensure that it is only the firm’s clients who benefit from the third-party research provided to investment managers.
From when MiFID II regulations are implemented on 3 January 2018, sell-side research firms will be restricted from offering research services as an incentive for portfolio managers in return for the execution of their order book. In particular, the regulations will introduce the obligation for asset management firms to pay for research entirely from their own pocket or from separate Research Payment Accounts (RPAs), set-up by the asset manager on behalf of their clients. Fund managers who choose the latter option will have to establish their research budget in advance, obtain client permission and ensure they document the ongoing value to the client for each and every research cost.
“He who pays the piper calls the tune”
Essentially, the unbundling of research and execution will prohibit asset managers from combining fees paid to investment banks for research and trading. Any un-costed or “free” research will no longer be allowed next year as it would be considered an inducement under new regulations.
Additionally, there are big challenges ahead for the sell-side too. Regulatory compliance and oversight will increase the cost base of providing research and now they face the difficult task of pricing their research. Instead of being able to bundle it together with execution and other services, research will now constitute its own line item on the balance sheet of both buy-side and sell-side firms. Developing a cost structure around something which has until now been perceived to be free is a challenge in its own right and raises difficult conversations about the true value of third-party research and how to price it on both an absolute and relative scale.
These changes aimed at protecting client interests will paradoxically and most likely have the opposite effect. The implementation of MiFID III will most probably result in a smaller market for investment research, as the industry shifts towards the unknown, a pull distribution model of explicitly buying products which have never had a price tag.
Fund managers will need to reconsider their approach to consumption of independent research services as they try to interpret and adjust to this new regulatory environment. And in doing so, it will most probably result in lighter wallets from which to pay the sell-side and a subsequent decrease in the number of research providers, either through closure or M&A.
In the short-term, this is bad news for clients, buy-side and sell-side firms – to be honest everybody besides regulators and those involved in interpreting it! In the long-term, my view is that such regulatory interference will be eventually repealed once the dust settles and negative impacts of less competition, higher costs, and higher client fees come to bear. If, however I am proved wrong and these regulations are here to stay, it will benefit firms like Woozle Research which offer differentiated, unique, and high value added insights into company fundamentals in a transparent and cost-effective model. I fear that for many brokers that offer neither global scale nor specialist sector/country insights they may very well find the road ahead challenging.
“Only when the tide goes out do you discover who’s been swimming naked” Warren Buffett