The fallout from the 2008 financial crisis led to a political sea change in opinion about the extent to which government should police the financial services sector. In 2011 EU internal market commissioner Michel Barnier set out his aim to establish a "single rule book" for financial services to try to prevent the excessively risky practices of the past happening again, while also reducing the decision-making powers of national regulators that had failed to stop some of these practices.
The Markets in Financial Instruments Directive II (Mifid II) is one of the most contentious and ambitious reforms produced in response to the crisis. The legislation will govern everything from where and how derivatives can be traded to the prevention of conflicts of interest among financial advisers. With the latter in mind, one of the aims of the European Securities and Markets Authority (Esma) is to unbundle equity research from the payment of dealing commission to brokers.
Under the current model, brokers are able to include payment for equity research under dealing commissions – the charges paid by investors when investment managers execute trades and acquire external research on their behalf. These charges are then passed on to clients via investment management fees. Yet in Esma’s view this would constitute an inducement under Mifid II and therefore a level 1 restriction applies.
The logic is that using dealing commissions to purchase research causes a conflict of interest for investment managers, as they use transaction costs to pay for this research. Under a bundled fee structure, a broker’s dealing and research commission increases. There is also the inherent conflict involved in a broker producing buy/sell/hold recommendations for a company that may be a client of the business elsewhere, for instance a major hedge fund client.
Some fund managers are ahead of the game. Earlier this year Woodford Investment Management said it would stop billing clients for research, arguing research costs were a "function of our role" and should not be borne by investors. Subsequent research by EY found around a quarter of fund managers planned to follow suit and absorb the cost of research, rather than passing it on to the end investor.
Removing the commercial incentive
Unsurprisingly, the reforms have not proved popular with the majority of brokerages. If investment management firms have to pay for research out of their own pocket, they will undoubtedly become discerning when it comes to paying for research. The knock-on effect of this is likely to be a much more competitive market for equity research.
Banning brokers from charging for research as part of dealing commissions will lessen the commercial incentive for brokers to produce research. Brokerages will need to bear the cost of producing equity analysis without any guarantee of being able to sell it. The consensus among analysts is that this will lead to a decline in coverage of certain stocks, particularly at the lower end of the market. Oliver Hemsley, chief executive of Numis Securities, says preventing institutions from paying for research out of clients' commission will have an impact on the amount of money paid for research. "A lot of shares are trading by appointment," he says. "It will be very detrimental to London as a centre for liquidity for small and mid-caps; the cost of capital will go up for companies and the cost of trading will go up."
Recently appointed Panmure chief executive and small and mid-cap specialist broker Patric Johnson says investors wanting a stake in a small-cap company post-Mifid II will be more likely to go to the house broker, since they tend to dominate market share in the trading of that stock and be the main liquidity provider. If there is less liquidity in the market this could amplify swings in share prices. Mr Johnson says Panmure will be tightening its concentration to ensure it remains the number one or two broker in terms of liquidity in the stocks it covers.
The new system
The FCA and Esma have proposed asset managers either pay directly for research or set up a ringfenced account for their clients, which would be used solely to pay for research from external sources. Any research account should not be used to fund internal research, which must be funded by a specific charge, agreed with each client. What's more, Esma has proposed that the amount of research obtained can also only be increased with written permission from the client and any surplus should be used to benefit the client. The charge cannot be linked to the volume or value of the transactions, plus the budget should be regularly internally assessed to consider the ongoing need of third party research.
Consolidation or capitulation?
Changes to the charging structure for research will pile more pressure on brokerages, particularly those covering small and mid-cap companies. The traditional stockbroking model, whereby companies pay an annual retainer and a lump sum for corporate finance deals and dealing commissions, is less stable. Rises in the capital buffers that brokerages are forced to hold by regulators have increased costs, plus fewer companies are using the stock markets to access capital, particularly on the junior market.
After the financial crisis there was a surge in consolidation among small and mid-cap brokers. Canada's Canaccord bought Collins Stewart Hawkpoint in 2011, Cantor Fitzgerald snapped up Seymour Pierce in 2013, Stifel Financial acquired Oriel Securities the next year and most recently Panmure bought Charles Stanley's securities division last year. The full list of brokerages that have merged, sold their cash equities business or scaled down their operations during the past 10 years is far longer. Part of the problem is that the broking market for small and mid-cap stocks is still overcrowded; against a backdrop of falling banking spend on external equity research. Independent analyst and former city stockbroker Nick Bubb says: "The problem for independent analysts and research houses is that there is still a ton of high-quality sector and company research coming out of the big brokers, mainly on large- and mid-caps."
Conflict of interest II
This is not the first time regulators have tried to clamp down on the use of client funds in payment for research. In 2012 the Financial Conduct Authority (FCA) issued its 'Conflicts of interest' document, which set out rules for investment managers purchasing research. Using dealing commission was permitted if certain criteria were met, including where research "is capable of adding value to the investment or trading decisions by providing new insight that inform the investment manager when making such decisions about its customers' portfolio". Mifid II is clearly a much fiercer piece of regulation.
Paying the price
With the introduction of the reforms delayed until January 2018, the majority of brokerages have not yet revealed how or even if their distribution models will change post-Mifid II. However, if investment managers have to pay directly to access sellside research, research products will naturally have a higher monetary value.
Numis chief Mr Hemsley reckons the broker's distribution of research will "inevitably" become tighter, but is yet to settle on details. Retail investors are not able to gain access to Numis research at present; however this is set to change via a pay-to-view-more system on the broker's website. "What we'll do in future is allow retail investors to access headlines and small amounts of it [research] and then if they want more of it they have to click through,” he says. Panmure plans to reduce the number of stocks it issues research on as well as scaling down its readership, says Mr Johnson.
For retail investors, the options to obtain equity research by analysts are already limited. These include bulletin board comments, media reports or research aggregators. Mr Bubb recognises it is getting even harder for private investors to get access to this research. "It used to be possible to get hold of most of the morning meeting packs, but most of the big investment banks have now cracked down on this sort of distribution," says Mr Bubb. This dearth of readily available research, coupled with the upcoming change in regulation, prompted the start-up of online aggregator Research Tree by former Liberum and Credit Suisse analyst Rob Mundy. However, after paying a monthly £40 fee, investors must also vault certain bars to be eligible to use the site. Coverage also has its limits: the majority of providers are smaller players, rather than the megabanks.
