Last week's Research Unbundling event hosted by Substantive Research in London was both significant and informative, and brought together representatives of all the stakeholders in the research market. Significant because the panel-based discussions provided a useful opportunity to measure the progress made by industry as a whole, and informative as the Q&A sessions and informal discussions enabled the participants to identify which aspects of MiFID II remain uncertain or unclear — unsurprisingly there are still quite a few of these.
The whole market is now moving from the lobbying to the building stage, with the buy-side in particular starting to firm up its unbundling strategy — several houses are already implementing some level of measurement and assessment of the research they consume, with valuation being the hot topic and main area of contention. Perhaps unsurprisingly, the sell-side are cagier as they struggle to reconcile internal cost models with consumers’ methods of valuation and expectations of pricing. Independent producers are possibly in the best position as they had to solve many of the issues created by MiFID II in order to exist in the first place.
Although the main themes were discussed in panels, we have chosen, rather unfashionably, to bundle them together by subject, as many of the themes were recurrent and overlapping — here they are, in no particular order.
The Regulatory Landscape
"Location, Location, Location..."
Although the precise picture of how MiFID II will be drawn up in each EU member state is still incomplete, a clearer landscape is slowly emerging from the fog of European Directives as the local regulators start to expand on their interpretations and expectations. Brexit notwithstanding, it is clear that there are two main blocs within the EU, with the FCA leading the Hawks whilst the AMF captains the Doves. It remains to be seen whether one flock will emerge victorious or the two models will be implemented in parallel, at the moment it seems that the latter scenario appears to be the most likely, despite this being the worst-case for the industry.
The FCA's position that RPAs should supplement CSAs is well known and does not seem likely to change. This is the most significant difference between the two blocs of regulators, as the AMF have stated that in their view modified CSAs will be sufficient to comply with their version of new rules on payment for research. We also obtained some clarity and guidance on other points from authoritative industry sources:
- Buy-side firms should have written policies on research measurement and purchasing
- Research procurement should be contractual and pricing should be ex ante with each component (e.g. Research, Corporate Access) priced separately
- Macro Research is substantive in the FCA's view, and therefore in-scope for MiFID II (Significantly, the AMF takes the opposite view, seeing macro as a minor, non-monetary benefit). Interestingly, the market is already showing willingness to pay for Macro Research.
- Where strategies are similar, funds may be grouped together for the purposes of budgeting and RPAs
- The FCA expect that firms will make reasonable endeavors to implement MiFID II on time, though they probably do not expect for everything to be done by the January 2018 (especially around Fixed Income Research, though they remained tight-lipped on this subject altogether)
- The FSA has published a third Consultation Paper on MiFID II, the deadline for responses is the 4th January 2017
In contrast to the FCA, The German regulator, BAFIN, has stated that they will not consult on local interpretations but will rely on ESMA Q&As and other regulators' input – they have indicated that their position on the Modified CSAs v. RPAs debate is closer to the AMF's stance than the FCA's.
The incompatibility of unbundling with the rest of the world, in particular the US, is still a major concern — there is currently no solution on the table and nor is one likely until the election season is over. US providers face a major dilemma in the fact that they cannot receive direct payment for research unless they become registered as Investment Advisors, which carries substantial legal obligations and risk.
MiFID II Implementation
"The End of the Beginning, not the Beginning of the End"
According to the oft-repeated mantra, the valuation of research is largely subjective. Nonetheless, if MiFID II is to have any chance of success then a framework for the assessment of research must be established and accepted across the industry. It looks like Originality, Actionability, Quantifiability, Depth and Consistency of Approach will be adopted as the core criteria for rating research, but questions still remain on what the will be the best scoring methodology — Is a five-star grading system too simple? Will anything more complex be adhered to? Although these questions were not answered at this event, much debate around them enabled certain reference points to be established:
- The spend on research in % terms should be roughly consistent across different strategies and products
- Research budgets should remain dynamic in order to reflect changes in the market
- The Pricing Model currently used by Independent Producers should be used with caution, because in the view of the sell-side it may result in pricing being too low
- The buy-side should begin to build their own research data library as soon possible, if they haven't done so already
With regard to the subject of valuation specifically, the research market infrastructure currently lacks an efficient feedback loop. Emerging and innovative usage and rating metrics will bridge the gap in helping consumers to better value and choose their research providers. Considerable investment will be needed by consumers to enable the visualization of data — a necessary step if it is to become actionable.
The mechanics of budget construction were also much debated, it is likely that the criteria to be used as the basic building blocks will include Strategy, Asset Class, Instrument or Expected Returns.
Other related challenges were also identified, such as the difficulties of measuring quality, and the problems around RPA budget construction. It was the consensus that various safeguards will be needed in order to protect clients, as there is a real danger that funds allocated from one customer could inadvertently be used to subsidize another, especially where a single research note could be reused across multiple asset classes but paid for from one RPA.
It is still uncertain how pricing should actually work — will consumers pay different amounts for the same note according to their utility? Will smaller consumers be forced to pay higher prices? Answers to these questions are unlikely to crystalize until the second half of 2017 when the various players will be forced to show at least some of their hands in order to comply with the ex ante pricing rules.
"Unknown Unknowns are the ones that we don’t know that we don't know"
in contrast to the view on equity-related issues, which is slowly but surely becoming transparent, fixed income remains opaque. Given this lack of clarity, it seems unlikely that January 2018 will be anything more than a soft deadline as many fundamental problems have yet to be addressed and the regulators are saying very little — the FCA have repeated that unbundling should enable spreads to tighten without providing a proper explanation as to why this should be, whilst the AMF seem to be focused solely on equities for the time being.
Pure Fixed Income Research is a relatively rare beast and in terms of its consumption sits upon layers of macro and equity research — this in itself poses questions around how the cost of these layers will be shared fairly across the user spectrum. The sell-side are the largest producers and as such dominated the debate, raising issues such as:
- Valuation — Given that two houses often quote the same spread for a bond but only one of them produces research on it, what is the value?
- Corporate Access — does a bond issuer roadshow count?
- Many houses in effect do their own fixed income research in the form of desk notes
- Given that the cost of Fixed Income Research is embedded in the price on an instrument, it is fair to say that such research cannot be viewed as an inducement and is therefore outside the scope of MiFID II?
Overall, the majority agreed that in terms of MiFID II, Fixed Income Research will eventually follow the Equity path, though quite a distance behind, and the market direction will be towards long-term, big thematic research rather than short-term highly specific notes.
The Future of the Research Market
"Beauty is in the eye of the Beholder"
MiFID II will undoubtedly be the catalyst for a seismic shift in the Research Market and the shockwaves it will cause may continue to reverberate for several years after 2018 as the market adapts to both regulatory and technology-driven change. Due to the current uncertainty the market is shrinking already and will continue to shrink in the mid-term, as consumers will take time to get used to paying for something that was always perceived as free.
Value will be driven by an instruments liquidity and the quality of the research, with the waterfront producers in particular struggling to adjust their model as research on blue-chip stocks will become almost worthless – indeed many questioned whether waterfront coverage will make any sense in the post-MiFID II world. Research on the small and mid-caps will improve and most-likely be taken up by local independent producers. The market will become more fragmented and varied as consumers become more selective and have a wider choice due to the new-found freedom post unbundling.
Despite the huge challenges facing the industry, overall the outlook was positive - the panic and anxiety seen at the beginning of the unbundling journey has largely been replaced by acceptance of what is coming and a sense of opportunity to shake-up the industry by innovation and improved efficiency... many of the smaller players on both sides of the research market are starting to recognize how they can benefit most from the level playing field that MiFID II is intended to create, whilst the larger firms will be able to shake off the blanket of inertia that has shrouded the industry for too long. Here's looking forward to next year's event!