Speech by Andrew Bailey, Chief Executive of the FCA, on the Markets in Financial Instruments Directive (MiFID II) at the European Independent Research Providers Association.
Speaker: Andrew Bailey, Chief Executive
Event: European Independent Research Providers Association, London
Delivered: 25 February 2019
Note: this is the speech as drafted and may differ from the delivered version
Highlights
- We maintain strong support for the MiFID II reforms. We will continue to supervise compliance with our rules to ensure improved conduct standards and value for money for investors.
- A number of fundamental changes have occurred in the market. Most notable has been the shift by a vast majority of traditional asset managers to fund research from their own revenues – instead of using their clients’ funds.
- We have heard loudly and clearly your views that, as independents, you cannot induce an asset manager to do anything except – hopefully – purchase your research services.
- We remain conscious that we do not necessarily have a full or clear picture, and will continue to monitor developments through engagement with firms and trade bodies.
I wish to start by acknowledging the role that independent research plays in supporting asset management in the allocation of capital across our economy.
That’s why I’m pleased to be here today to share some thoughts on recent regulatory changes, and to listen to your feedback.
MiFID II came into effect almost 14 months ago. It represents a major piece of post-crisis regulatory reform, that has strengthened standards across financial markets, and the investment firms that offer and intermediate services.
As part of these reforms, MiFID II completed the long journey from bundled commissions to a framework that requires a clear separation by asset managers between execution and research payments.
One principle of the reforms is to ensure that portfolio managers act as good agents in the best interests of their client – and that their discretionary investment decisions are not unduly influenced by third parties.
This is consistent with the FCA’s focus, including in our Asset Management Market Study and subsequent remedies work.
In tandem, MiFID II seeks to improve transparency, reduce potential conflicts of interest, and promote competition by unbundling brokers’ activities.
I’m keenly aware of how important these reforms are for each of you, and the real-world impact this has had on your businesses.
Today I will focus my remarks on three areas:
- First, what positive impacts have we seen in the initial implementation of MiFID II?
- Second, what are the challenges and concerns that we have heard?
- Thirdly, I’ll outline what we are going to do, and how we see competition evolving in the research market.
I hope to leave you with a clear sense that we maintain strong support for the reforms. We will continue to supervise compliance with our rules to ensure improved conduct standards and value for money for investors.
At the same time, we are keen to ensure effective competition in this market and will listen carefully to concerns about possible barriers to it.
But first, I’ll provide a bit of context to this long-standing debate.
Context
Supply & demand for research prior to MiFID II had little to do with ‘normal’ market mechanisms, and instead owed much to the introduction of minimum commissions by the members of the London Stock Exchange (LSE) back in 1912.
The fixed commission regime created a market whereby brokers – being unable to compete on execution costs – sought to differentiate themselves by offering a range of non-execution services alongside trading, including research.
Despite the wave of change that culminated in 1986 with the Big Bang and the end of the fixed commission regime, industry norms remained entrenched when it came to the provision of research.
Indeed, a boom in equity trading and the growing importance of institutional investors increased demand for analyst coverage which, as in the United States, continued to be paid through ‘soft-dollar’ arrangements.
Fast forward 30 years, and after a lengthy debate in the UK and at EU level, unbundling has become a reality through MiFID II.
So what positive impacts do we perceive just over a year into the new MiFID II regime?
A number of fundamental changes have occurred in the market.
Most notable has been the shift by a vast majority of traditional asset managers to fund research from their own revenues – instead of using their clients’ funds.
The scale of this shift went well beyond our expectations in the summer of 2017, when surveys suggested two-thirds or more of buyside firms would continue to charge clients for research.
In conjunction, there has been robust discussion around the value and price of research as an embryonic market place emerges.
The market is going through a period of price discovery, and is probably yet to find an equilibrium.
However, what is becoming clear is the price of written research is much lower than initial forecasts ahead of MiFID II. I will return to this topic later.
Finally, from initial observations, it is also apparent that new technology is changing not only the nature of research but how this is supplied, monitored and valued by the buyside.
So that’s the 30,000-foot view. But what have we seen on the ground?
Since summer last year we have been carrying out a multi-firm review including buy-side asset managers, sell-side brokers, and independent research providers.
Our findings suggest that the new rules are having a positive impact on the accountability and discipline of the buy-side when procuring research, and on the cost of execution.
Our findings suggest that the new rules are having a positive impact on the accountability and discipline of the buy-side when procuring research, and on the cost of execution.
Dealing commissions have fallen – not only due to the removal of research costs, but also because managers are increasingly using more electronic, ‘low-touch’ channels.
Our work also largely confirms public reports that research budgets have reduced by around 20%-30%.
Overall, we estimate that the reduction in charges incurred by investors in equity portfolios managed in the UK was in the region of £180m in 2018. Assuming similar savings going forward, this equates to nearly £1bn over the next 5 years.
Importantly, buy-side firms have indicated they can still access the research they need. This may reflect the low ‘entry level’ prices for written research, alongside more thoughtful consumption across the board.
Turning to the sell-side, the emergence of pricing and a recognition that research is a service in its own right and should be paid for has taken hold, although we recognise that price discovery is continuing to evolve.
What are the challenges, and where have we heard concerns?
Now, let me reflect on areas where concerns have been raised. These have centred on the scope of the MiFID inducements regime for you, as independent providers, pricing, and other potential unintended consequences of the reforms.
I’ll tackle each in turn.
Scope
Front and centre are the concerns you have shared with us on the scope of the MiFID II inducements regime.
From an asset manager’s perspective, the ‘black letter law’ on inducements does not differentiate between whether a research supplier is a broker - where a conflict of interest can clearly arise – or an independent provider like most of you here.
We have heard loudly and clearly your views that, as independents, you cannot induce an asset manager to do anything except – hopefully – purchase your research services.
In transposing MiFID II, we used national discretion to provide a degree of flexibility and created a ‘trial period’ exemption so that research can be freely received by firms for up to 3 months.
My staff have also been keen to stress at public events like this that we will be risk-based in our supervisory approach.
For example, we have already said that, irrespective of trial periods, independent providers can pitch for business and offer sample material on an ad-hoc basis without it being an inducement for an asset manager.
We will also consider whether any changes to ‘trial periods’ may be beneficial to ensure they have the intended effect.
In summary, while we cannot change the baseline restriction in MiFID II, we have exercised flexibility in our rules where we can and we do intend to be pragmatic about this.
In summary, while we cannot change the baseline restriction in MiFID II, we have exercised flexibility in our rules where we can and we do intend to be pragmatic about this.
Pricing
Understandably, pricing is a sensitive topic for all of you here today.
MiFID II requires brokers to price research separately from execution activities so that the cost of research is not influenced by, or conditional on, execution payments. This means that brokers cannot offer favourable terms for research to reward trading clients.
In turn, asset managers must consider whether accepting certain pricing levels could still give rise to a conflict of interest, in other words if what they receive is so cheap as to call into question whether it is genuinely divorced from trading or wider relationships with a broker.
Importantly, very low pricing also raises competition questions about the future of a sustainable and diverse research market in the interest of consumers.
This is something we are keen to scrutinise and test – especially low-cost ‘all you can eat’ packages, or one-off events such as conferences priced substantially below cost.
But things are not quite as simple as that.
Larger sell-side firms have different economies of scale and scope than smaller players and the ‘right’ price will ultimately be a function of the market. Overall competition on quality and price is good for the buyside and the consumers they serve.
Having said that, we remain conscious that we do not necessarily have a full or clear picture, and will continue to monitor developments through engagement with firms and trade bodies.
The European Commission has launched a study on the impacts of the MiFID II reforms on the research market, and we will carefully consider its findings once public.
Other potential unintended consequences
Many have expressed concerns about the potential negative impact of the new rules on the research coverage of smaller companies and the liquidity of their shares on secondary markets.
To ease this potential impact, we took certain steps ahead of MiFID II by:
- allowing free distribution of research that supports capital raising events;
- allowing issuer-sponsored research – an important source of coverage for smaller companies – to be freely circulated; and
- clarifying that research made publicly available cannot be an inducement.
Since implementation, we have watched for changes in coverage of smaller companies.
I think the evidence is, so far, inconclusive, and does not suggest the dramatically negative impact that some predicted.
I think the evidence is, so far, inconclusive, and does not suggest the dramatically negative impact that some predicted.
Data for the 2015-2018 period show that analyst coverage levels on the LSE’s Main Market and on the AIM have remained broadly consistent.
Similarly, LSE order book data for 2018 point to a material increase in trading volumes between 2018 and 2019, especially for small caps, suggesting liquidity has been maintained in the market.
Competition and the way forward
We are now completing our supervisory work to assess how the rules are bedding in, to analyse their impact on asset owners and consumers and, more widely, on the market for research.
We intend to provide more formal feedback in the second quarter of this year.
What is clear though is that an effective price discovery process must be based on a robust determination of the value of research.
Value will mean different things to different people; whether supporting the generation of ‘alpha’ or helping to benchmark and validate internal research ideas.
Effective price discovery is predicated on the emergence of evaluation criteria and metrics to price research prior to consumption, as well as evaluating it ex-post.
This process should consider the quality, and not just the quantity, of research inputs, and how this informs a firms’ investment decisions on behalf of its clients.
The importance of this process is underpinned by our accountability framework that requires fund managers to consider value for money, and allocates responsibility for this to a senior manager, to assess the value offered by a firm’s funds in the best interests of investors.
So purely tracking interactions with research providers and overly rigid payment schedules, may not adequately capture the value of research and provide a fair payment to those who supply it.
For some firms, a better link between a procurement-focused finance department and the actual users of research – the frontline portfolio managers - will help to ensure that the research they are purchasing reflects the needs of the investment teams, and ultimately, benefits the underlying clients.
Conclusion
So, to conclude.
The unbundling of research remains one of the most debated aspects of MiFID II.
Other regulators around the globe are looking on with interest at how things are developing here, and we have heard that asset owners outside the EU are putting pressure on asset managers to unbundle research from execution costs, to follow the example set in MiFID II.
Overall, we consider that the rules are already having a positive impact.
Overall, we consider that the rules are already having a positive impact.
We are seeing changes in behaviour which are starting to deliver the intended effects – reducing conflicts of interest, improving accountability and producing cost savings for investors.
It is also clear that the market is still evolving, and that we quite likely have not yet found the right pricing equilibrium for research – or felt the full benefit of competition – in a market which was previously characterised by opaque pricing and weak competition.
The new framework is designed to increase accountability but to be fully effective it relies on, and seeks to promote, a competitive market for research.
Competition creates winners and losers – this may mean some consolidation in parts of the market and, hopefully, new opportunities for those offering the best products and services.
We want to see independent research providers continue to play a key role in this landscape and will listen carefully to your concerns.