The second installment of the Markets in Financial Instruments Directive will, like its predecessor, bring sweeping change to Europe’s capital markets
The ‘cornerstone’ of European financial markets regulation – the original Markets in Financial Instruments Directive (MiFID) – has been in force across the EU for the past six years. In light of the financial crisis, however, that cornerstone is now being revised in a bid to strengthen investor protection and bring even greater transparency. But how does it affect investor relations?
The European Securities and Markets Authority (ESMA) published its final technical advice in December 2014, three years ahead of its January 2017 deadline for EU-wide implementation of MiFID II (the directive) and MiFIR (the regulation). Though both will have an impact, for ease of reading and since many interviewees referenced MiFID II, that is what this article will refer to. The mammoth 446-page document covers a vast array of issues but two key areas of interest stand out for IR professionals: research and corporate access, with reporting requirements and trading regulation also having an impact.
Sanford Bragg, Integrity Research
‘One of the big talking points on MiFID II so far has been the fact that ESMA stepped back from its most headline-grabbing proposal to completely prohibit the use of client monies to pay for investment research,’ says Michael Hufton, CEO of corporate access platform ingage. ‘But this does not mean business as usual – far from it.’
Indeed, debate continues as to what exactly ESMA expects when it comes to paying for research. ‘The biggest question mark surrounding the final role for MiFID II relates to whether or not client dealing commissions can be used in any form to pay for research,’ explains Sanford Bragg, CEO of Connecticut-based Integrity Research. The UK’s financial regulator, the Financial Conduct Authority (FCA), has already aired strong opinions on the subject – and Bragg says it is interpreting ESMA’s text as constituting ‘an outright ban on paying for research with commission.’
Elsewhere, however, he says ‘there’s some disagreement on how the language is interpreted. German and French regulators have the view that the intention of the regulation is to allow a limited, but still significant, ability to pay for research with client dealing commissions. So there isn’t consensus among the regulators that would be tasked with enforcing this. There are [also] regulatory and political pressures to stop short of an outright ban.’
Even if the softer approach wins out in the end, the technicalities involved in paying for research via a client-funded research payment account means some asset managers may simply find it more convenient to pay for research out of the P&L – something even ESMA recognizes.
‘If the portfolio manager (or independent investment adviser) chooses to pay directly for research out of its own resources either by absorbing the costs of research or by increasing its headline fee (annual management charge or advice fee), then it may do so subject to requirements on general disclosure and managing conflicts of interest,’ ESMA states in its technical advice. ‘Investment firms that spend small amounts on research may prefer this method of paying for it in order to limit their administrative burden.’
Whatever the final wording, when it comes to the impact of these potential changes for the IR community, the message is clear: small and mid-caps will bear the brunt of any cutbacks in research. For David Knox, founder and CEO of independent research house Lazarus Partnership – which offers specific menu pricing to its clients – says it’s hard to find a positive angle when it comes to the direction research is taking under MiFID II. ‘Investors are already thinking very hard about every pound they spend on buying in research services,’ he says. ‘It has to be very carefully thought through, it has to be acquiring substantive research that adds something to their investment process, and they have to be able to demonstrate that.
Michael Hufton, ingage
‘In many cases they have almost gone so far as to adopt what they think the regulation might look like or at the very least what they know the tone of the regulation is. That has an inevitable consequence: investors spend less.’ For the smaller companies in particular, ‘[IROs] have to be worried that the propensity for their companies to be followed by the sell side will fall’.
One firm that expressed this concern directly to ESMA during the consultation process is Kepler Cheuvreux. Robert Buller, global head of account management at the Paris-headquartered firm, expands on the potential implications of any reduction in the amount of research published on small and mid-cap companies. ‘Less research could lead to some very interesting ramifications in terms of asset prices in that there [could be] less price discovery based on public information,’ he explains. ‘Very savvy asset managers will potentially be able to buy mispriced assets and make quite a lot of money out of them.’
He also says a reduction in research could even hit the number of small and mid-cap firms choosing to go public. ‘Quite a big incentive for vendors or CEOs to list their companies is that they continue to own equity themselves, or, as CEOs, they will be paid partially in stock or paid partially in relation to stock price performance,’ he says. ‘If there is very little research coverage of that stock – generally the case if it is a small or mid-cap – that means the creation of that price is going to be much more difficult than in the past.’ And that could turn companies off the idea of listing in Europe, he adds.
It’s not all bad
Source: IR Magazine Global Investor Relations Practice Report 2014
One potential benefit is an increase in the quality of research as budgets are scrutinized. While Hufton expects this to happen, and research by the UK’s IR Society last year found respondents anticipating a similar shift, Knox says this is likely to be felt only at the margins. ‘[MiFID II] should force people to write better research,’ he says. ‘But the reality is that, commercially, it just might not happen.’
So how should IROs prepare for MiFID II’s impact on research? As this will potentially affect smaller companies, many of whom already struggle to get satisfactory coverage, Bragg says they should find and cultivate relationships with boutique firms that specialize in their industry, as well as hone their investor targeting skills. ‘Some would argue that the quality of the research at the boutique firms is better because they’re focused on a particular sector and know it well,’ he notes.
‘Then there are firms like Edison that charge fees to companies for coverage. That’s not a model that’s widely accepted [at the moment] but I think it may become more common for smaller publicly traded companies.’
The issue of using dealing commissions to pay for corporate access has been on the radar for some time – with the FCA again taking a strong position against it – and, as such, most IR professionals will be well aware of what could be in the pipeline. But while the regulator last year clarified that, under its definition, corporate access does not qualify as research eligible to be paid for out of client research commissions, Bragg says the subsequent shift in behavior hasn’t quite played out the way the FCA anticipated.
‘It expected this would reduce spending on the part of asset managers on corporate access using client dealing commissions,’ he says. Instead, corporate access now includes greater analyst involvement. ‘Analysts are chaperoning or hosting corporate access engagements [and] writing summary notes on those engagements,’ he explains. ‘These are construed as meeting the test of research and therefore making at least a portion of the corporate access activity payable with client dealing commission.’
Emma Burdett, partner and head of investor relations at Maitland and chair of the IR Society’s policy committee, adds that while the FCA made it clear brokers could not be paid by fund managers for corporate access, it did not offer guidance on how changes should be implemented. As a result, fund managers are taking a variety of approaches, she says: ‘Many brokers are waiting to see how the research issue pans out before making a decision on corporate access and research together.’
In addition to questions around the impact of the FCA’s rules last year, corporate access is another area where opinion is divided on just how clear ESMA’s technical advice is. ‘The MiFID II guidelines really are silent on the topic of corporate access,’ says Bragg. ‘If all research ends up being banned from being paid for with client dealing commissions then of course corporate access would be affected by that. But if paying for research with client dealing commissions is still permissible, given certain constraints, it’s not clear what the impact will be.’
He notes, however, that ‘regulators on the continent may well follow the FCA’s lead on their own and increasingly scrutinize corporate access. I think IR professionals can expect corporate access to continue to be an important way of interacting with asset managers. For now, it appears the investment banks remain a critical conduit for corporate access, even though there are new technologies being floated to try to disintermediate that relationship.’
Emma Burdett, Maitland
One of those new technologies is offered by Hufton. While acknowledging that, as it stands, MiFID II ‘doesn’t really prohibit any activity that’s going on now’, he nevertheless maintains that ‘for an IRO, the existing model of corporate access cannot continue.’ This is, he adds, because corporate access will fall ‘squarely outside’ the list of activities that can be paid for using client commissions.
‘Anything given for free is an inducement,’ he explains. ‘You can give something for free only if it’s a minor, non-monetary benefit. [ESMA] has published a list of what counts as a minor, non-monetary benefit – and corporate access is not there.’
As such, he says IROs should be aware there will be an explicit charge for something where there wasn’t before. That’s not to say that more clarification isn’t needed. ‘What we don’t know is how that becomes priced,’ Hufton observes. ‘Do they bill the company? Do they bill the investor? How do they do it?’
One impact of the corporate access evolution is that behavior among the big institutions is beginning to change, he adds: ‘More and more are wanting direct access in a way that didn’t exist before.’
Time and money
As well as being aware of a potential increase in the number of institutions seeking direct access, IR professionals should focus on their targeting efforts, says Burdett. To do this, many will need to look at how they allocate time and resources.
Research by the IR Society published in October 2014 highlights concerns as to how the burden and cost of corporate access would shift. More than half (52 percent) of the 400 IROs surveyed anticipate spending more time on investor targeting, event logistics and investor feedback during 2015, compared with just 3 percent who expect to spend less time on these activities. ‘It’s inevitable that corporates are going to have to increase the resources they’re prepared to put into investor relations,’ says Burdett, though she acknowledges that differences in company size – and so in IR team size – can limit what’s available.
Like the changes to research, many expect the new corporate access rules to disproportionately affect smaller cap sizes. In fact, 61 percent of respondents to the IR Society research say the impact of banning commission payments for corporate access would be either ‘negative’ or ‘very negative’ for smaller-cap issuers, with the expectation that brokers would focus on large caps instead.
To counter this, IR departments need to be rigorous about where their money is going, says Burdett. She suggests looking at how much time you could save by asking some of the advisers you’re already paying to help with the logistics of organizing an investor day, for example. IROs should also ‘make sure they’re not paying a corporate broker an annual retainer and then not getting much of a service in terms of corporate access and investor targeting for that,’ she adds.
It’s also worth looking into the range of products now available ‘that can save you time and don’t necessarily cost you more money when you offset it against how much your time is worth and what the value-add will be,’ says Burdett.
Spotlight on trading
ESMA is attempting to bring a heightened level of transparency to trading, following some of the unintended consequences of the original MiFID legislation. ESMA’s plans ‘will have an impact on taking what has traditionally been a dark market into being a lit market,’ points out Jerry Slason, data specialist at investment management consultancy Investit.
Among other things, ESMA has its sights set on:
- Dark pools – the ‘double volume cap’ means the amount of dark-pool trading (the true extent of which is not really known) in any given stock will be capped at 4 percent for a single venue and 8 percent across all venues. Any stock that breaches the limit will face a six-month ban from trading in the dark and will have to move to lit venues, such as stock exchanges
- Automated trading – ESMA plans to regulate algorithmic and high-frequency trading, with traders required to register their proprietary formulae with regulators after a proposal for a mandatory half-second freeze on orders was dropped
- Brokers’ crossing networks – the regulator is seeking a ban on these networks, which link brokers and dealers without the need for a public exchange. Unlike dark pools, these are not anonymous but a ban would further push trades onto ‘lit’ venues
- Open and transparent trading – for all asset classes, not just equities as targeted by the original MiFID legislation.
As exchanges and traders take steps to implement MiFID II ahead of the 2017 deadline, IROs should familiarize themselves with where their shares are traded – including, if possible, the extent to which they are traded on the alternative venues of dark pools, crossing networks and multilateral trading facilities.
All major financial data platforms will be able to offer information that can help you get a clearer picture of where your shares are traded and what the daily volume is at each venue, as well as who is behind those trades – though there are free options available as well. But the ‘big issue here’ is ‘how this is going to affect liquidity,’ says Slason. ‘What is this going to look like four or five years down the road?’
Reporting big data
Best execution is another area ESMA is looking at, says Christian Voigt, a senior regulatory adviser at technology provider Fidessa. There is a misconception among some that ‘best execution is only relevant for equity markets or only relevant where there’s more than one exchange where you can trade a certain instrument,’ he observes. ‘[But] more and more in the industry, those two statements are not necessarily true. You can also have best execution for single markets and derivatives markets, for example.’
While the focus on this area is not necessarily new, an FCA review in 2014 finds that few firms are doing enough to deliver best execution. In order to do this, however, there will be some ‘massive systems requirements’ according to Hufton – and that could lead to more consolidation among execution platforms as smaller brokers struggle to afford changes, he says.
This could also mean increased direct market access as ‘more institutions look to deal themselves in order to guarantee that they’re getting best execution,’ Hufton adds. Another requirement he believes could lead to greater direct market access is that under MiFID II, ‘every fund manager will have to disclose its top five brokers, volume traded and results achieved’.
Of course, all the data involved in delivering best execution also has to be put to use, adds Voigt. ‘Obviously everyone, whether from the buy side or the sell side, is somehow expected to digest all those reports published by everyone else in order to then make an informed decision regarding their own order,’ he says.
In fact, MiFID II as a whole has a big emphasis on reporting, and the systems required to meet these demands will be big and costly. And, once again, it is likely to be the smaller firms that find themselves hardest hit. The impact of these rules could ‘play into the hands of either the very big and established or the very good and established – of whom there aren’t that many – and if it’s a relatively new enterprise, even someone like us, then they’ve got to have something very different and truly essential to the investment process,’ says Knox.
‘Possibly the unintended consequence of all this is precisely the opposite of what regulators might want to see. [Depending on how it pans out], you will potentially have less coverage, less liquidity, less efficiency, less entrepreneurialism and more concentration in the hands of the chosen few that already constitute the big, established players.’
Markets in Financial Instruments Directive II timeline
This article appeared in the summer 2015 print issue of IR Magazine