Fixed income research has been the poor cousin in the MIFID2 unbundling consultation/legislative process. To date almost all the attention has been paid to equity research and how the new rules will apply. At our Unbundling Uncovered event on November 3, we discussed this subject in great detail with our panel of experts, from both the buy side and sell side. Here are the 7 key issues raised by that discussion.
1) Increased costs; almost impossible to pass on
Come January, 2018, there will be a new cost line item for investors, and there’s little chance fund managers will be able to claw back that cost from their end- clients. As one global fund manager told our audience, in the current low interest rate environment firms cannot bear this additional cost at a time when the fees they receive from end investors are already incredibly tight and where there is very little clarity about increasing the fees in the future. Passing on the cost of fixed income research will be almost impossible. This will be a major constraint to demand for sell side research.
2) What will still be free?
Very little, according to our panel. This hinges on the interpretation of what constitutes a ”minor-non monetary benefit” (i.e what can still be distributed for free), and what might be considered as an ”inducement” to trade (must be paid for). The latest guidance from the French financial regulator gives the impression that it will take a more benign view on this, while the FCA will be more strict in the enforcement. Some fund managers on the panel bemoaned the lack of clarity on the interpretation and how it should be applied. Consequently, these fund managers said they would prefer to take a very conservative view, and plan to consider almost all the research they receive as substantive, and therefore should be priced. Moreover, sell side banks and brokers will probably tighten/cut off the distribution of free research. Given the way the regulations are being applied across the financial industry, one fund manager argued that there would be little interest from banks in sailing close to the regulatory line and so they will probably police this policy quite strictly.
3) Surely FICC research isn’t an inducement to trade? One panelist explained that due to the poor advocacy in the lobbying process (prior to the delegated acts), there had somehow been a presumption that the inducement regime would apply to fixed income. The logic of how it applies to the equity market is well understood. Whereby, best price is ubiquitous, and where research could potentially be used to channel trading into particular venues, which might be considered an inducement to trade. Panelists agreed that this situation didn’t apply in fixed income, due to it being a principal-based market, where best price is time variant and can change at every moment. Therefore, the requirement for entities to trade on the basis of best price means that it was not possible for fixed income research to be an inducement, the panelists told delegates. So an inducement regime is being applied to a market where one isn’t required.
4) Your sales access just got very expensive
The new rules are also being extended to sales coverage. Any value-added service from sell side sales teams would be considered research, which is set to place constraints in terms of the ability of the buy side to engage with sales people at banks. So the question is not just; Are you going to pay for research? But are you going to pay for your sales coverage and the value added coverage that you require? In the equities market there are sales traders and research sales, and our panelists said the same concept will probably be adopted in FICC, where value-added sales people become part of the research team, and part of the research budget. Panelists say this will be a particular area of contention. Interestingly, said one of the panelists, the interpretation from French regulators is that sales coverage maybe exempt, but in all other jurisdictions it will not be. Some panelists expressed their concern that this could really be a major potential blockage to the level of information flow from the buy side to the sell side, with a negative impact on market liquidity.
5) What are fund managers prepared to pay for?
Hard to say, because it will depend on the asset class. Our fund manager panelists saw this in two ways. Firstly, that one said he would buy niche/specialist research that his firm didn’t cover internally, or didn’t have the expertise in, while another said that where the research was thematically strong and could be broadly applied across a range of asset classes and products, it was easier to justify the outlay. In single-name research, one panelist said that single-name sell side credit research offered little value, and that it won’t probably exist in 5-years time.
6) What’s the price?
Price discovery is cited as one a key factor creating uncertainty in the implementation process, with the banks being reticent to disclose their pricing schedules. The starting point is that budgets will be much lower for fixed income than they are for equities (which will in some cases be part-funded from CSAs). Fund managers were inclined to talk down the monetary value of sell side research, while our sell side participants emphasised the cumulative value of FICC research, arguing that value shouldn’t be assessed on a piece-by-piece basis.
7) Paying US brokers for research directly is prohibited:
At the moment you cannot pay a US broker for research directly. In order to do so banks will have to become investment advisors, but the liability of banks in doing so is enormous. For the buy side, especially large global firms, the rule causes all sorts of complications. For instance, many global asset managers have analysts spread globally who are all part of the same team. Now they will have to figure out how they can interact with each other when using the advice and information they have derived from the research they have received in areas outside of Europe.