INVESTMENT COMMUNITY PERSPECTIVE

What is MiFID II (other than an acronym that sounds like a new flu strain)?

Regulations on Markets in Financial Instruments and Amending Regulations go by the acronym MiFID II and originate from the European Commission. The combined pieces of legislation provide a European-wide legislative framework for regulating the operation of financial markets in the European Union. (With a positive Brexit vote, who knows how these two pieces of regulation play out in London.) The laws are focused on enhancing ‘investor protection’; the underlying presumption must be that investors are not adequately protected and thus more rules and regulations are required in order to correct some perceived inequity. Upfront, I declare my bias against MiFID II.

The focus is directed mainly at professional money managers, rather than ‘Joe/Jane Investor’ trading a personal account. One way to highlight the underlying issues is to think of commissions paid by professional money managers on stock trades. Theoretically, trade commissions are meant to pay for a number of items: trade execution (including capital to execute the trade), research provided, actual out of pocket trade costs (higher than you might think), sales advice, corporate access (bringing companies by for marketing), etc. Each of these items can be subdivided; think in terms of salaries, capital consumed, equipment used, the development of evolving technologies, and so on. Commissions are a ‘small amount on large volumes’ type of issue; think billions, not millions, of shares.

No More Spreading the Love… the Old Fashioned Way

Effectively, MiFID II wants to split the cost of trade execution from the cost of providing research; this is similar in nature to how electricity and natural gas bills have been ‘disaggregated’. So commissions will be paid on trade (and I suspect sales will be part of ‘trade’) and likely at a lower rate; then separate cheques will be issued to pay for research. The idea is that the best trade execution will be sought and the best research will be sought. Money managers will not be ‘spreading their trade around’ in order to pay for research; rather, a separate cheque will be issued for research. Money managers currently spend a fair amount of time (and money) on commission tracking systems in order to decide whom to pay with commission dollars. In addition, money managers do cut cheques today for research they deem worthy, produced by sources with whom they do not have a trading relationship. In addition, some money managers pay commissions to the key companies with which they decide to trade and then direct a portion of the commissions to pay for research.

But Everybody Wants Free Research

If there is one thing that holds true in the capital markets, it is that everyone wants free research. For years I have received requests from people and organizations asking for research, never asking how they may pay for it, just wanting it sent to them free of charge. Some even admitted to using discount brokerage or trading elsewhere and were miffed that research would not be provided free of cost. The reality is straightforward: no account – no research. Putting a price on research is a difficult thing, as it has different value to different people. Consider that the smaller the investor, the less able (and the less willing) he or she is to pay for research. This is why small accounts are aggregated by dealers and the costs spread out over a wide (commission paying) audience.

Trade Commissions Head South

As an overall trend, trade commissions have headed in one direction: down. Many years ago, a rule of thumb was that for every share traded, the average commission was $0.05. Those days are long gone, and reality today is likely much less than half that, sometimes a quarter, a tenth, or less; it depends on volumes traded.

And More Exchanges Have Popped Up

More exchanges have opened up and they all charge fees for trading on (and ‘hooking’ onto) their platform. Stock traders are required to always ensure best execution on trade (a regulatory requirement); accordingly, dealers need connections to all available trading platforms. Therefore, as commissions come down, the actual cost of trading has increased. The bottom line is that sales commissions typically cannot support sales, trading and research. Underwriting and advisory fees are required to float the boat. 

White Label Trade Platforms Level the Field

Unlike in Ferris Bueller's Day Off, the trading world no longer hangs out on the trade floor, making hand signals while ‘chalking up’ trade. Trades today occur on computers (electronic trading), simultaneously trading on many exchanges and using sophisticated hardware and software. Block trades do occur, with growing infrequency and more often on illiquid stocks. With the slow exit of block trading, the amount of capital required on the trading desk to execute trade is diminishing. The trade hardware/software arms race still occurs, but the pace of development has slowed. Now there are a number of different providers of hardware/software (Bloomberg and Fidesa Consulting, to name a couple) that will furnish traders with the tools to trade. Although the software can be customized, effectively trade is being commoditized, and one could argue that so, too, are the various exchanges. (If you want to understand the world of ‘electronic trading’ read Flash Boys; I had the distinct privilege of working with some of the key characters in the book who ‘cracked the code’ on high frequency trading.) 

Money Manager Fees Also Head South

By the same token, money manager fees have fallen. The money managers compete with Exchange Traded Funds (ETFs), whose fee structures are razor thin. ETFs are usually structured as index funds and are typically agnostic with respect to individual stocks. ETFs are not consumers of research and the minimal trade commissions they pay reflect this.

Economies of Scale

Everyone is under pressure, which means everyone is striving to gain the advantages of economies of scale. Given the overarching cost pressures everywhere, are the rule changes necessary? The European Commission believes so but the trading world is changing more quickly than regulations. 

MiFID II Likely Leads to Less Research, Rather than More

Given cost pressures everywhere in the industry (and current trends), MiFID II is more likely to whittle down research choices. Firsthand experience with independent research suggests to me that the prospects for this business are not promising, especially longer term for cyclical industries. If MiFID II is adopted in North America, given the choice of paying for outside advice (which will eat into management fees) or developing an internal research team, I believe the latter is more likely. Again, economies of scale will kick in. The big get even bigger and the small run the risk of marginalization. Competition decreases and the barriers to entry increase. Is this a good thing? It depends on your perspective. 

How does Joe/Jane Investor Win? He/She Wants Performance, Not Protection

Presumably if the Joe/Jane Investors of the world have their investments professionally managed, they will seek the best advice for their money. Remember that ETFs are a tough bogey for money managers to beat. If my fund underperforms, I can simply change managers, or buy ETFs. My belief is that market forces are applying ample pressure on professional money managers and there is little margin for error. In many respects, the market is extremely efficient. However, when it comes to the Joe/Jane Investor's personal trading account, how does he/she ‘pay for research’, if not by commissions? (If the investors want to do their own homework, they can use a discount brokerage account and they likely do not receive research.) Selling research online has not proven to be a profitable business venture. Selling reports for a buck a pop is not likely to cover costs, let alone generate a profit. Unlike music, most research does not have a long shelf life; I am still very happy listening to the Beatles, but reading a four-year-old report on TransCanada PipeLines is another story.

What about North America?

Rules and regulations differ in North America, and we have yet to see whether MiFID II actually delivers on its objective, or whether the law of unintended consequences rears its ugly head. The noise of MiFID II is loud in Europe, with some limited discussion in North America. I suspect Canada and the U.S. will wait and see. Historically, the Americans are loathe to adopt European standards in anything. I point to the metric system and accounting standards (IFRS) – Canada adopted both while the U.S. ignored both. (Metric is merely a relative measurement, while I have yet to meet anyone in Canada who thinks the adoption of IFRS was a good thing for Canadian companies.)

How Could this Affect You, the IR Professional?

Until we see how things evolve in Europe, it will be best to just monitor the situation. Research ‘deaths’ are likely to be immediate and then slow, with startups minimal. Consider that a research analyst typically has an associate, computers and phone equipment; quote services, subscriptions, offices and the cost of travel (not insignificant), plus a sales desk. Costs add up quickly. The odd analyst might go it alone but only if he/she believes the economics will work. Many large fund managers already have their own research teams. These may get beefed up with time, but IROs likely visit with both the analyst and the portfolio manager already (and dealer sales desks certainly help to ensure meetings with the right people). I suspect that many participants (buy-side and sell-side) will take a wait and see approach. Could dealers look to spin out their research departments? Sure, but if they do, it is likely because the returns are expected to be marginal, so who is the buyer?

Whittled Down Research Means Greater Self-Reliance

If research gets whittled down further, it will likely be underperforming research analysts who exit quickly or industry coverage that is no longer deemed profitable; this is an ongoing reality in any case. If your company is in an affected industry, you have likely been dealing with this already. It probably means that you either have only a couple of firms covering your company and helping to market your company, or you have become self-reliant. Most European investment dealers have already witnessed downsizing and restructuring in order to adapt to market pressures, MiFID II may already be moot. If things were not already tough enough in Europe, the prospect of changes may mean that many Canadian companies focus more on the North American markets and ignore marketing in Europe until the dust settles.

Dirk Lever is Managing Director, Institutional Equity Research, AltaCorp Capital Inc.