Executive Summary

Implementation of the MiFID II directives in the U.K. and Europe is now less than a year away. European, U.K. and U.S. asset managers no longer have the luxury of time to address the changes necessary to be MiFID II compliant. Greenwich Associates recently conducted a study canvassing U.S. and European buy-side investment managers to gain insights into how they are preparing for the MiFID II directives. This will be a momentous time for global equity markets, and clarity about the ramifications following the January 3, 2018 implementation date is gradually emerging.

Global Changes to Internal Processes

While determining the full extent of MiFID II on U.S. asset managers remains a murky endeavor, many are working to ensure the ripple effect from across the pond doesn’t turn into a tidal wave. Numerous U.S. asset managers with substantial business in the U.K. and Europe are choosing to adopt global practices to lessen the burden of maintaining distinct research management processes in different regions. In theory, as large global investment managers adopt global processes, smaller firms will follow suit.

Although brokers prefer accepting bundled payments, pricing research and accepting payments in a myriad of different formats is a hassle. Furthermore, when institutional investors begin to see increased transparency in their European investment research spend, they may mandate that their other investment managers do the same. As such, if the global goliaths unbundle, U.S. investors will likely do so as well—despite the lack of a regulatory directive.

Implementation of the MiFID II directives in the U.K. and Europe is now less than a year away. European, U.K. and U.S. asset managers no longer have the luxury of time to address the changes necessary to be MiFID II compliant. Greenwich Associates recently conducted a study canvassing U.S. and European buy-side investment managers to gain insights into how they are preparing for the MiFID II directives. This will be a momentous time for global equity markets, and clarity about the ramifications following the January 3, 2018 implementation date is gradually emerging.

Global Changes to Internal Processes

While determining the full extent of MiFID II on U.S. asset managers remains a murky endeavor, many are working to ensure the ripple effect from across the pond doesn’t turn into a tidal wave. Numerous U.S. asset managers with substantial business in the U.K. and Europe are choosing to adopt global practices to lessen the burden of maintaining distinct research management processes in different regions. In theory, as large global investment managers adopt global processes, smaller firms will follow suit.

Although brokers prefer accepting bundled payments, pricing research and accepting payments in a myriad of different formats is a hassle. Furthermore, when institutional investors begin to see increased transparency in their European investment research spend, they may mandate that their other investment managers do the same. As such, if the global goliaths unbundle, U.S. investors will likely do so as well—despite the lack of a regulatory directive.

Anticipating such a shift, 43% of the U.S. respondents plan to make global changes to their research evaluation practice. The remaining 57% will be in “wait and see mode,” allowing the directives to play out before they act. While feasible, none of the U.S. firms will implement two separate processes for each region, citing the immense administrative burden and cost. In the U.K., 69% plan to make global changes, with 15% modifying only their European systems. The remaining 15% are already MiFID II compliant and will not require further changes.

Although many of the U.S.-based asset managers are rightly waiting to let MiFID II play out in Europe, they’re paying attention. The rationale behind the MiFID II directive acknowledges that when an asset manager uses their clients’ money to pay for research, they might not be a responsible buyer. Furthermore, the trading desk’s pursuit of best execution should not be influenced by the procurement of research.

To be compliant, large global and European asset managers are increasingly becoming “fully unbundled,” meaning they have completely removed the trading desk from the research evaluation process. In the U.S., 64% of responding firms have already sheltered traders from the research vote. That percentage grows to 76% in Europe and 79% in the U.K.

Direction is Clear, Magnitude is Small

The greatest concern for research providers both large and small is that MiFID II will prompt a substantial decrease in buy-side research spend. When asked about how firms’ overall research budget will be affected, close to 40% of respondents predict a decrease.

Regarding client commission dollar usage for research, a similar 40% expect a decrease. This percentage was amplified to over 50% when European firms were isolated. A clearly negative trend persists, but only translates to a calculated 5% decrease among U.S.-based firms and a 7% decrease in Europe and the U.K. Although relatively modest on a firm level, this could contribute to a near $300 million decrease in U.S. research commission spend and over €100 million in Europe, based on 2016 Greenwich Associates estimates.

Asset Managers Have Options

MiFID II will allow asset managers to pay for investment research via two methods: a hard payment directly from the asset manager’s account, or through a separate client research payment account (RPA). Those opting to make a hard dollar payment directly will take it from their own P&L. For the minority firms that rely on in-house research in lieu of the Street’s offering, a payment from their own P&L will be business as usual. With an estimated research/advisory commission pool of $5.9 billion in the U.S. and €1.58 billion in Europe, heavy consumers of external research will have to rethink their process.

Many buy-side investment managers breathed a sigh a relief when European regulators clarified that CSAs could still be used to fund the new RPAs. Since inception, CSAs have grown in popularity as a tool to meet best-execution requirements while enabling the correct research provider to be paid. Currently, 74% of U.S. buy-side investment managers use CSAs, with an estimated 36% of the total U.S. commission flow running through their pipes in 2016. The U.K. has a similar adoption rate with 83% of firms using at least one CSA.

Conversely, Continental European firms have been late adopters, with only 36% of them using CSAs, a number sure to increase in the coming months. Although this mechanism separates the execution and research transactions, MiFID II will add the RPA to ensure investors have transparency into the cost of research.

We asked study participants how likely they will be to switch to hard payments for the majority of their research needs in one year and five years’ time. Unsurprisingly, 84% of U.S. institutions and 68% in Europe said such a switch in one year is unlikely.

Fast-forward to five years out, and while only 25% of U.S. firms think a hard dollar switch is likely, the tables turn in Europe. Sixty-one percent of European respondents and 52% in the U.K. project that they will be paying for research primarily with hard payments. This suggests that although MiFID II will allow managers to continue use of client commissions, European firms are hoping to move in the direction of hard payments.

However, pressures on active management fees would make it difficult to charge institutional investors to fund hard payments. Also, taking on the expense would be another hit to firms’ P&Ls in a time when active management returns have suffered. The five-year time frame allows investment managers to comprehensively review their investment practices to determine whether a hard payment model is feasible.

Implications for Research Providers

For European and global asset managers, the time to fully unbundle is here. We may therefore begin to see varying implications for the affected investment research providers. Currently, U.S. buy-side institutions allocate about half of their research budget to bulge-bracket broker-dealers, a third to midsize regional brokers and the remainder to non-brokerdealer third parties.

When asked if their allocation would change within two years post MiFID II, little change was seen in the U.S. The question elicited a similar reaction from U.K.-based firms, but surprisingly, continental Europe is expecting a different reaction.

Study participants are predicting the bulge-bracket allocation to decrease by almost 10% to 56%, with midsize dealers and IRPs getting larger allocations of 30% and 14% respectively. The different reaction between U.K. and European accounts could be a function of current preparedness of U.K. firms. Many of them may have already adapted their research processes, so little additional change is expected in the next two years.

Bulge-Bracket Broker-Dealers

Given their sheer size, resources and influence on the rest of the industry, the bulge bracket arguably has the most to gain and the most to lose post MiFID II. Interestingly, study participants predict a decrease in global investment bank usage—to the tune of about 4% (7% among European institutions). These numbers are in line with the predicted decrease in overall research budgets, but higher than the expected 3% decrease from regional and sector specialists.

Many investment managers actually see redundancy among the offerings of the large investment banks. The head trader at a large global asset manager in the U.S. explained, “If I no longer have to compensate the bulge bracket through trade flow, and they are providing the same research offering as their peers, I have no problem ending our research relationship.” She did mention that she will continue to compensate bulge-bracket brokers for corporate access meetings, due to the unparalleled connections they are able to set up. With pricing models for service expected to rise, smaller firms in particular may well decrease their consumption of bulge-bracket research.

MiFID II will likely have a significant effect on the execution side of large investment banks as well. Having the most dynamic algorithms, trade tools and liquidity sourcing offerings, the bulge bracket stands to gain from a fully unbundled world. With buy-side traders blind to research transaction, best execution will continue to be the main focus.

One respondent from a European bank explained, “Currently the selection of brokers is based on execution and research. In the future, there will be a pure focus on best execution requirements.” TCA may gain importance with the increasing need for data-driven execution-quality benchmarks. The buy and sell side will bolster their proprietary TCA systems, while third-party fintech providers continue to penetrate the market.

Firms using CSAs to fund their research payment accounts have the liberty of consuming research from any broker, since the research commissions will be directed straight to research providers. With execution quality as the main objective, investment banks will compete head-to-head with execution-only platforms that may invest more to increase the competition. The results from our 2016 Comprehensive Commission Rate Study showed little movement in commission rates paid in developed markets, but we may see movement post-MiFID II unbundling.

Midsize Regional Brokers

Although smaller than the bulge bracket, regional brokers rely on their local footprint, small to mid-cap stock coverage and market knowledge to capture buy-side research and execution business. This differentiation will be essential to staying on buy-side broker lists, as study participants predict a 3% decline in use of country and sector specialists. Currently 51% of European institutions have already unbundled their payments to regional brokers.

In order to maintain the status quo, the 42% that now bundles their payments will have to adopt the CSA-funded RPA method. On the other hand, 8% of U.K. respondents currently pay using hard dollars—a number likely to increase in the coming years.

Midsize dealers must focus on their core competencies to successfully compete with each other, the bulge bracket and independent research providers. While unbundling could potentially help the large investment banks increase their trading volume, the smaller brokers may miss out. One of the strengths of regional brokers is their knowledge of local markets and the small to mid-cap stocks within the region.

International and especially emerging markets investors rely on smaller brokers to guide them through the difficult and less accessible markets. One emerging markets hedge fund trader explained, “I now exclusively use regional brokers to help me find liquidity. I don’t want to hear from my Hong Kong coverage at a bulge-bracket firm if I’m trying to trade in India. The trade just won’t be executed effectively and efficiently.”

If regional brokers forego the internal investment required to compete on speed and technology, they will have to find their niche or outsource their execution services in order to stay relevant. Some may explore exiting the equity trading business altogether if their current desk is more of a “cash register” to collect research commissions. Whether it’s regional expertise and knowledge of local liquidity or a robust sector research offering, with investment managers securitizing each sell-side relationship, regional brokers should focus on differentiation.

Independent Research Providers

When asked about their firm’s expected use of independent research providers (IRPs), the jury was mixed with no discernable direction of change. However, IRPs often get overlooked when investment managers discuss their research consumption, in part because research is used on an as-needed basis and also because IRPs are often left out of research evaluations.

Fifty-seven percent of research participants include IRPs in their research evaluation, while 40% pay IRPs on a subscription basis. Many IRPs have moved to a subscription model, complaining that they’re often omitted from receiving meaningful commission allocations when they’re included alongside full-service brokers in formal research evaluations. Those buy-side firms that currently have subscription models have, in essence, already unbundled.

IRPs may have a leg up on their larger broker counterparties, since many don’t have to adapt their business models. Some are already MiFID II compliant, and furthermore, any trading regulation won’t affect them. Given their smaller size and simpler product, we likely will see them implement IRP subscription or “a la carte” pricing models faster, which help facilitate the required transparency for the valuation and pricing of research.

The big concern for IRPs is that if investment managers cut their counterparty list, they will be the first to go. Although 61% of study respondents use a single soft-dollar budget when allocating client money to IRPs, 24% use a separate budget designated for non-broker-dealer third parties. Investment managers continuing to use client commissions to pay for research will have to weigh IRP research spend in a single budget against other larger research.

Again, differentiation and proving themselves integral to the buy-side investment process is the recipe for success for IRPs. When reviewing research budgets, buy-side managers will look to cut potential overlap in research coverage. If IRPs can remain differentiated, there will always be money headed their way.

In-House Research

Bringing research analysts in-house is another option for investment managers who don’t want to pay a third party and are looking for an alternative to paying the Street. When the MiFID II directives were first announced, many managers reflexively declared in-house research was their future. A deeper look at the effect on their balance sheet, however, led many to re-examine their options. With the clarification that client commissions could still be used to pay for research, reactions have tapered. Even so, 34% of study participants are expecting an increase in their use of in-house research—an average change of 4%.

The feasibility of hiring more research analysts internally is limited for some managers. Active managers that have seen dramatically reduced returns since the lucrative post-crisis years won’t be able to absorb the extra cost. Likewise, clients expecting similar results won’t be willing to undertake the additional cost if it doesn’t result in better returns. Further, although in-house research allows managers to remain proprietary in their research and trade ideas, access to the Street is often crucial to understanding the consensus opinion on companies.

This strategy may work for passive managers and for those who value proprietary opinions, but the harsh reality is that unless they are willing to invest heavily, buy-side firms will not be able to replicate the same access and consumption of research to which they are currently accustomed. 

What Does This All Mean?

It will take some time to determine if the regulators “win” and are successful in increasing the transparency in the use of client funds by investment managers. However, in doing so, study participants are predicting shifts in research/ advisory trends that will cause changes for everyone involved in the process. Investment in core competencies and separation from the competition will determine who survives in the aftermath of MiFID II.

We’ve reached the point in the buildup before MiFID II when the buy side is having conversations with their sell-side research providers to facilitate the ongoing research exchange that supports their equity investment business.

At the same time, banks are discussing with their clients what level of research consumption and spend will be necessary to continue to provide sufficient returns in a post-MiFID II environment. Greenwich Associates will remain at the forefront of MiFID II research during this significant period for global equity markets.

Methodology

From October through November 2016, Greenwich Associates interviewed 99 buy-side U.S. and European equity broker liaisons, heads of commission management, and head traders. Respondents answered a series of qualitative and quantitative questions about the structure of their research budgeting, evaluation and payment process, and expected impacts from the changing regulatory landscape as a result of the MiFID II directives coming out of Europe.