The Markets in Financial Instruments Directive (MiFID II) regulation, with over 1.4 million paragraphs of rules, has been designed with theagenda of restoring investor confidence and making the European market safer and more transparent. MiFID II covers all categories of trading within the European Union (EU), irrespective of the fund manager's location.
After 17 months of implementation of MiFID, some interesting trends have been revealed, especially pertaining to aspects such as
unbundling of trading and research costs. On the one hand, smaller companies are running the risk of losing out on institutional investors.
This is an outcome of the sharp decline in paid research, preventing cost-sensitive banks from researching smaller firms. On the other
hand, new ventures are emerging, which seek to research ignored small and mid-cap stocks. Increasing grievances from small and midsized
investments firms might catalyze a review in the near future. However, the benefits of increased transparency that MiFID II
facilitates must be kept in mind.
The refurbished version of the Markets in Financial Instruments Directive, or MiFID II, was designed to offer better protection and
increased transparency to all asset classes, ranging from equities to fixed income and foreign exchange. Implemented on January 3, 2018,
the MiFID II has more than 1.4 million paragraphs of rules, which have increased in complexity since implementation.
REGULATION WITH OVERARCHING CHANGES
The new rules cover all aspects of trading within the EU. If a fund manager wants to buy an underlying product listed in the EU,
such as a bank option in Hong Kong, it will fall under the scope of MiFID II, irrespective of the fund manager's location.
The MiFID II goes beyond the instance listed above. One of the key differentiating features of MiFID II is the aim to push more
trading away from the phone and on to electronic venues, which possess better audit and surveillance trails.1 That will lead
to a surge in data, which will be measured in petabytes. It is now mandatory for institutions to report more information about most
trades immediately, including price and volume.
Trades will also be timestamped, to 100 microseconds for some, while information in documents for transaction reporting will
stretch to more than 65 fields. It must be stored for a minimum of five years, while banks and brokers will have to compulsorily
show customers that they were offered the best available price for their trades.2
CHANGING THE WAY OF INVESTMENT DECISIONS
One of the most prominent aspects of the regulation governs the way asset managers pay for the research they use to make
investment decisions. Before the introduction of MiFID II, asset managers received research, including written reports and analyst phone calls, free of charge. These research costs were later incorporated into the trading fees, which had to be settled by the end
clients. Under the new rules, fund managers will now have to budget separately for research and trading costs, a move known as unbundling.
The new mechanism on research payments poses notable challenges for U.S. brokers. Local rules do not permit U.S. brokers to receive direct
payments for research unless they are formally registered as investment advisers. However, a 30-month exemption has allowed U.S. banks to accept payments from European fund managers.3
The U.S. Securities and Exchange Commission has signaled that the regulator would support routes around the U.S. rules that fund managers have crafted, enabling
them to strike a unifying standard for research payments. How it will take shape is yet to be decided.
ASSESSING THE IMPACT OF MIFID II
Seventeen months on, MiFID II is changing the investment banking business, with asset managers concentrating their negotiating
power on a smaller list of the largest brokers. The regulation seems to have shrunk the research coverage, particularly among small and mid-sized companies.
MiFID II has imposed cleaner divisions between payments for trading and those made for research. The new standards imply
that asset managers need to pay for the research they use, rather than simply sending their dealing commission to banks. This has
profoundly impacted the entire sales, trading and investment banking infrastructure in Europe.4
According to a survey in February by the CFA Institute, nearly 60 percent of asset managers were taking less research from banks
than they were before the introduction of MiFID II. The price asset managers pay for research has also suffered a steep decline, thereby squeezing banks' profits.5 The fears that niche segments would bear the brunt
of unbundling and the regulation would raise barriers to entry for small mid-cap specialists appear to have realized, with a wave of cutbacks by brokers such as Canaccord.6
MiFID II could also create a vicious circle, where cost-conscious banks stop researching smaller companies. Those companies could
then lose their profile among institutional investors and their stock becomes less attractive and trades more cheaply, making it less
appealing for investors to buy and for brokers to cover.7
The European Commission, which proposes legislation, is now preparing a review, after receiving several complaints especially from
small and mid-sized investment firms in this area.8 However, there is no clarity as to whether there is a genuine political will to make
changes. European elections have delayed tweaks to the regulation. Furthermore, not everyone is in favor of making sweeping
amendments to the regulation. Most EU managers produce market research on their own or buy only what is needed from banks.9
According to the U.K. Financial Conduct Authority, the market disruption caused by MiFID II is a price worth paying for increased
Some areas still remain uneasy. A study by Italian regulators into MiFID II's effects found more research was being generated to
benefit computer-based and algorithmic-driven research.
Despite the challenges, the market has started filling gaps. Bolsa de Madrid (BME), the Spanish exchange operator, for example,
has started a venture with local financial analysts to provide independent coverage after finding 60 listed small and mid-cap stocks
that were previously not tracked.10 There could also be a form of incentive from the government in the near future, such as a tax
credit, to stimulate research reports on small to medium-sized companies.11 Public-private collaboration and EU-wide
standardization of reporting requirements will also make research cheaper.12
MiFID II is already shaking up equity investing throughout Europe. Requiring asset managers to pay separately for research,
thereby forcing brokers to lay out the details of its cost explicitly, has led to a steep drop in spending.13 That has affected brokerage profits, resulting in a reduction of the quantity and quality of research they do.14 Smaller companies are
the ones research providers have dropped from their coverage. Less broker attention could result in less investor attention, thereby making
such companies' stocks less liquid and this, in turn, would be still less attractive for investors.15 A remedy for this could be that asset
managers undertake their own research, or for non-brokerage companies to find a profitable niche in it.16
If MiFID II unintentionally makes capital markets less accessible to smaller companies, that reflects a failure in the market for company
information. The cost of researching a company is directly related to its size, which is also one of the prime reasons small
companies are undercovered. When markets underprovide a public good, such as valuable information, public intervention becomes inevitable.17
In order to prevent MiFID II turning into a bane for capital markets, all solutions need to be pursued within the EU's capital markets
union agenda. That agenda will ensure adequate liquidity for smaller EU companies.
1. Article by Financial Times, What is MiFID II and how will it affect EU's financial industry?, September 2017.
3. Article by Financial Times, How MiFID has made its mark in the US, May 2019.
4. Article by Financial Times, Where now for the rules that rocked European finance? May 2019.
13. Article by Financial Times, How to guard against MiFID's unplanned effects, May 2019.