CFA Institute

One Year After MiFID II: Regulation Favors Industry Consolidation

With the intent of alleviating potential conflicts of interest between investment managers and their clients when transacting with brokers, the European financial services industry underwent its biggest regulatory overhaul in over a decade.
The revised Markets in Financial Instruments Directive (MiFID II) was born and came in effect 3 January 2018. The new regulation introduced new trade-transparency requirements in equity and fixed-income markets, strengthened requirements for the provision of investment advice, and enacted new product governance rules.
The provision of Investment research was disrupted by the changes to portfolio management inducements rules, including the requirement to set prices and charge for research separately from trading costs (commissions and spreads). This has broken the historical business model of investment firms bundling research with transaction costs, which are deducted from the client’s account.
MiFID II Has Caused a Shake-Out Among Research Providers 
Research from the CFA Institute has found that the introduction of MiFID II last year led to a decrease in both the amount and quality of coverage – particularly of small- and mid-cap stocks.
Rhodri Preece, Head of Industry Research at CFA Institute
Rhodri Preece
Rhodri Preece, Head of Industry Research at CFA Institute, commented:  “MiFID II has brought transparency and competition to the investment research business. But as asset managers have absorbed research costs, we have seen a notable reduction in research budgets that is causing a shake-out among research providers. Independent and sell-side research providers are under pressure, which we see translating into reduced research coverage, particularly in small and mid-cap equities, and fewer sell-side analysts.”
The study found that asset managers are overwhelmingly absorbing research costs against their profit and loss and scaling back research budgets accordingly. Larger asset managers are moving research production in-house but there is a perceived reduction in research quality and coverage, particularly for small- and mid-cap equities, which could hurt liquidity and capital formation in that sector.
“Costs have resulted in firms reducing the number of third-party research providers and thus have less access to different sources from which to derive investment advice and ideas”, said a portfolio manager cited in the CFA Institute paper.
Another portfolio manager suggested authorities to eliminate the unbundling of research and execution on the fixed-income side: “This has just decreased [the] availability of research, decreased the quality/breadth of research, and taken further liquidity out of an already illiquid market.”
As research provision retrenches and overcapacity in the supply of research is being removed, investment professionals perceive the research marketplace to be more competitive overall. It is still unclear whether an equilibrium has been found that serves the best interests of end-investors.
CFA Institute conducted a survey of its European members, a sample of 12,633 members, with 496 responses being received from 449 different firms across 25 different European countries. The top 4 occupation categories represented are portfolio manager, research analyst, C-suite, and financial advisor/wealth manager, accounting for 60% of respondents.
The survey found that independent research providers have not benefitted from MiFID II as 57 percent of buy-side respondents report sourcing less research from investment banks than before the regulation came into effect.
 “Decrease in Research Costs Are Putting Independent Brokers at Risk”
Research budgets have been scaled back – with the average decrease in research budget being 6.3 percent – and the reduction in budget increases with firm size: for firms managing more than Euro 250 billion of assets, the average budget reduction is 11 percent, whereas, for firms managing less than Euro 1 billion assets, the budget change is negligible.
Buy-side participants mostly believe that research quality is unchanged, but sell-side respondents are generally more pessimistic, with 44 percent believing that research quality has decreased overall. Less than 10 percent of respondents across both buy-side and sell-side believe research quality has increased.
Research coverage has gotten market participants concerned, as 47 percent of buy-side respondents and 53 percent of sell-side respondents reported a decrease in coverage of small and mid-cap stocks. “Only larger cap names are being well covered.
Investors are concentrating their pools of research [on] the larger firms and bringing more of the research in-house. This means that only larger asset managers will be able to cover more names”, said an investment banker.
As previously stated, on the positive side is that the research marketplace is now more competitive, according to 39 percent. In contrast with 25 percent who believe the research market is less competitive.
“MiFID II favors large asset managers with scale. In [the] future there will be less competition in asset management. MiFID II also favors large research providers with scale. There will similarly be less competition in research provision. Gains from scale will result in a great deal of consolidation in asset management and in research provision. The resulting economies of scale will see lower fees charged to end-investors but at the expense of vibrant price discovery in capital markets. The result will be poorer allocation of capital in our economy”, said a portfolio manager.
One sales agent on the sell-side cited in the CFA Institute document said the significant decrease in research costs are putting independent brokers at risk. “This should result in the closure of several independent brokers and an even larger dominance of global and financial institutions–backed brokers, which should also hurt the buy side down the road.”