Equity Research Meets New Regulations
When the Markets in Financial Instruments (MiFID) II legislation takes effect in January 2018, the field of equity research will undergo a dramatic shift. MiFID, which was initially rolled out in 2007, provides uniform regulation for investment services across the 28 member states of the European Union (EU), plus Iceland, Norway, and Liechtenstein. The updated legislation, MiFID II, mandates that EU investment management firms—such as hedge funds, asset managers, and others on “the buy-side”—dramatically change how they receive/pay for research. Though MiFID II only applies to buy-side investment firms and sell-side research providers in the EU, it’ll likely affect their counterparts in the U.S. as well. As currently constituted, these buy-side firms can receive research from sell-side equity research firms and banks as a free add-on to other services that the investment firm receives from the sell-side bank, or in a bundle with these other services. However, the new MiFID II legislation will require these firms to pay for sell-side firms’ research directly.
This research includes written reports sent to all of a firm’s clients, reports requested by specific clients, as well as provides access to members of the management team of the companies that are being researched. These resources can be of great value to buy-side firms which might not have the bandwidth to conduct research on all the companies that the sell-side firms cover, or might not have the same level of research abilities or expertise as the sell-side firms, even regarding companies that they both cover.
In the months leading up to the MiFID II implementation, both buy-side and sell-side firms are dealing with a number of new issues. One such issue, for both the buy-side and the sell-side, is determining proper purchase prices and payment mechanisms for the research. More specifically, buy-side firms will now have to either pay for research out of their own pockets or reach an agreement with the specific sell-side firm to have the firm pay for the research. The latter option can only proceed as long as the research element is given separately from other services that the sell-side firm provides—i.e. is unbundled. An issue that will be faced solely by the buy-side is determining how much research they’ll need to buy, given that it’ll now be priced independently, and may ultimately be more expensive. As a result, if many buy-side firms decide that paying for equity research is now too expensive, they’ll pay less for research, which will have a detrimental effect on the sell-side research firms and independent research providers in the EU, plus those in the U.S. with European clients.
Since MiFID II only applies to firms domiciled in the EU, one could surmise that the result would be that both buy-side and sell-side firms in the EU will adapt to the new changes. However, things aren’t so simple. EU buy-side firms don’t receive their research from sell-side firms strictly in the EU—they also receive research from sell-side firms in the U.S. As a result, sell-side research firms in the U.S. are faced with the decision to either charge their EU clients in a method that is approved by MiFID II but continue to charge their U.S. clients as they traditionally have or unite around the MiFID II standards for all of their clients, both EU and U.S based. The latter decision would have significant ramifications on the regulatory status of their research, as well as possibly cause them to lose clients. Theses firms may also decide to simply drop their EU clients which would significantly hurt their business. As these regulations develop and possibly spread from the EU to other regions of the world, investment banks and independent research firms will have to rethink how the business of sell-side equity research can remain profitable while maintaining the quality expected from professional security analysts.