The EU is rolling out new rules for banks and Mifid 2 Research regulations will change a lot in the financial industry from high fees to laying off analysts
Banks and financial institutions have become used to bowing to regulators’ demands with the tidal wave of regulation that has swamped the financial services industry since the great financial crisis. However, in less than a year’s time, the industry will face its largest test when one of the most ambitious and contentious sets of financial reforms from the European Union will come into force.
These reforms are the second installment of the Markets in Financial Instruments Directive — better known as Mifid 2 — and are especially far-reaching because many asset managers will find themselves having to comply with additional layers of red tape for the first time.
It’s estimated that the introduction of these regulations will cost the industry a total of €2.5 billion in the most contentious part is the so-called unbundling of research. Mifid 2 requires asset managers to budget separately for research and trading costs. The problem asset managers have is that many customers may not be prepared to pay extra for research, as more often than not, it is not needed.
According to the Financial Times, investment banks have a total annual budget for research of $16 billion, sending 40,000 pieces of research out to clients every week. But only 2% to 5% of these research emails are actually opened and read.
To put it another way, if the whole research industry disappeared overnight very few people would actually notice. With this being the case, it’s no surprise that at the end of last year of 220 asset management executives across Europe surveyed, more than half still did not know how they will pay for research when Mifid 2 comes into force.
Asset Managers – Unprepared For Mifid 2 rules
To try and survive, research providers will have to change their business model and convince asset managers that their work is worth paying for, no easy task considering the number of research reports that go completely unread. The reinvention of the equity research business is something Mckinsey & Company’s analysts consider in a new research report entitled “Reinventing Equity Research as a Profit-Making Business.”
The report notes that after the introduction of the rules for the first time “bank and broker-dealer equity research will operate as a free-standing profit center, forcing a transformation of the business. The buy side will pay broker-dealers for actionable research that adds investment value, but the demand will fall far short of the mountains of research that banks currently supply ‘for free.’”
McKinsey speculates that the upcoming changes will have an enormous impact on the industry and could see revenues fall by 30% for research providers.Specifically, McKinsey states:
The consensus among the buy and sell side expects a 30 percent fall in payments for research, and some firms expect a drop of 50 percent
However, the consultancy does not believe that this will be the end of the research industry, rather it will lead to more focused and productive research. Instead of banks sending out a deluge of unneeded information, the banking industry will restructure in a way where a few global banks lead the industry with both global execution services and high quality, broad-based research coverage. Other firms, but cannot meet these requirements will offer execution-only to customers with no research. There will also be a group of banks that sit in the middle of these two, institutions that try to maintain their current position and subsidies operations with income from wealth management and banking. McKinsey believes this group of institutions will live on borrowed time and will have to make significant cuts in one direction or another.
Most research outfits will try to refine their offering, rationalizing research and execution capabilities by focusing on their “home field advantage,” although demand from “local and global clients will likely support one to three such banks per region.” The one group that will benefit more than most according to McKinsey is specialist research and independent research firms as they zero in on clients looking for a specialized skill set.
Mifid 2 Changes Will Be A Major Challenge For Active Managers
Producing bespoke, one-of-a-kind research will help providers survive in a competitive market, but there’s the elephant in the room in the form of passive investing.
Active investment managers, such as hedge funds and mutual funds will be the predominant buyers of investment research. However, investors are increasingly turning away from active products towards cheaper, passive investments thanks to active managers’ apparent lack of skill. For the ten years ended December 2016, more than 80% of US active managers underperformed their market benchmarks. Meanwhile, according to McKinsey hedge funds generated a cumulative alpha of -5% between 2011 and May 2016, after providing investors with a cumulative alpha of 139% from 1993 through 2011.
Investors have reacted by throwing funds at passive instruments with $400 billion of assets moved from active to passive strategies during 2016. Hedge funds saw net outflows of $100 billion in total during the year. This trend will undoubtedly only increase the pressure on both research providers and research buyers to produce research that worth buying and produce results. Extra charges from active managers for research may only speed up the exodus.
According to research from the Tabb Group, over the past ten years, almost $3 trillion has moved from discretionary stock-picking funds to index-aligned investment strategies. This massive shift has impacted 95% of US equity funds according to responses of 95 senior traders at asset managers. The combination of the move toward passive investing, unbundling, and low volatility has the US equity institutional investor commission pool down 7.5% from 2015. And surprisingly, managers have almost no plan to fight back. Of the 95 traders surveyed, 35% responded that the only action being taken was to “hope this trend changes.” 11% replied that they were reducing costs to cope.
Research conducted by AIMA shows that around two-thirds of alternative asset managers have now made decisions around how to pay for research; 80% plan to charge investors and the remaining 20% intend to absorb the costs themselves. 35% of the respondents indicated that they have still not decided where the cost will fall.
The AIMA survey shows just how far-reaching the new Mifid regulation will be. Even though the European Union is introducing these rules, half of the alternative asset managers with offices outside the EU surveyed said that they intend to apply Mifid II rules applying to best execution globally. This figure jumps to 90% for alternative asset management firms that delegate portfolio management from the EU to a third country.
Finally, we are starting to get some numbers and they are high.
Bloomberg News reports:
Nomura Holdings Inc. has proposed that clients pay as much as 120,000 euros ($134,000) a year to access their favorite analysts.