The second incarnation of the EU’s Markets in Financial Instruments Directive, commonly referred to as MiFID II, will take effect in less than two months. The new directive has been a long time coming, with its activation already pushed back a year from the initial intended start date on concerns that the market was ill prepared. Nevertheless, MiFID II should be seen as a necessary and inevitable evolution of the original Markets in Financial Instruments Directive, implemented in 2007 and intended to be a cornerstone of EU efforts to unify European financial markets to rival the depth and dynamism of the US capital markets.
Although the original MiFID did succeed in lowering costs and expanding choices for investors, weaknesses in its structure became apparent with the onset of the global financial crisis in 2008, and MiFID II is intended to further reduce systemic risk and strengthen investor protections. The delayed implementation of MiFID II should not in any way signal a lack of resolve on the part of EU regulators. The increasingly frenzied preparations that market participants are belatedly undertaking are more indicative of the growing realisation, and acceptance, amongst the entire investment community that business practices and market behaviour will soon be changing, meaningfully.
The implications of MiFID II for a variety of market participants have been well-rehearsed. Banks and brokers on the sell-side will have to separate the cost of research from that of trade execution, with a knock-on effect on fund managers, who will be required to report their own expenditure on research.
MiFID II is intended to inaugurate a new era of transparency, cutting expenses for individual pension savers and investors as the true cost of execution versus the broader investment research process and other functions becomes known.
While the presumed benefits to end investors and the challenges to established practices faced by their fund managers and other service providers are well known, the practical impact of this “unbundling” of process costs on the companies that issue tradable financial instruments has, so far, gone largely unaddressed.
Such businesses, which are the source of many trillions of pounds’ worth of debt and equity securities globally, will, we believe, experience a seismic shift in the way that those instruments are discussed in an investment context, and ultimately valued, once MiFID II takes effect.
Once unbundling becomes a reality and research is no longer subsidised by sales and trading fees and commissions, the generally sub-commercial nature of sell-side research and corporate broking retainers is likely to become more evident. This is likely to have far reaching consequences on the commercial behaviour and priorities of market participants, with the bottom line being that all market participants will be far more selective in deciding what to buy and, from the perspective of IR services, what to offer. Companies must begin preparing now to understand the opportunity cost – and hence commercial value – for their investor relations activities, and set aside appropriate budgets to provide for the levels of activity that they wish to maintain in a MiFID II environment.
While some brokers may be planning to maintain current service levels, MiFID II will require brokers to charge commercially realistic fees, which implies a meaningful uplift in fees in the absence of cross-subsidy from other business lines. That would be arduous enough for companies seeking to maintain research coverage and investor access, but the reality is that many broking firms will simply not be able to maintain their current breadth of research coverage, particularly for companies where the broker has no formal retained relationship in place.
Companies will also find that the broking relationship will no longer drive coverage decisions at the brokers: one of the consequences of MiFID II rules is that such decisions will need to be made by research departments themselves, as independent profit centres, free from the influence of other divisions. If sufficient deep-pocketed fund managers are not willing to pay for research on a company, it is likely that it simply won’t be published.
Some buy-side firms will choose to internalise the costs of research by bolstering their own teams, which corporate issuers will find difficult to influence. But between them and the newly MiFID II-compliant (and streamlined) sell-side research provision, the new directives are also likely to support the rise of independent research providers.
As now, the value of what those independent houses publish will have to be assessed on a case-by-case basis, and it remains to be seen how the circulation of independent research will compete with the established distribution platforms and franchises of the existing sell-side network. Nevertheless, this proliferation of new research providers is likely to result in a more crowded and fragmented market of ‘expert’ voices which will still need to be handled by in-house company IR teams. The time and resource needed to maintain this increasingly complex and dispersed network of relationships is unlikely to be an abstract consideration for companies, as it is likely that companies will increasingly have to subsidise or sponsor research to ensure that it is written and published.
There is a final challenge. While companies must understand and accept that MiFID II will change industry practices, what is almost certainly unlikely to be impacted are the commercial imperatives of the investment community. This means that something else has to give, and that is most likely to be market behaviour. It is this consequence that will make MiFID II so relevant to company boardrooms and the maintenance of effective IR.
The terms of MiFID II are likely to give the sell-side, fund managers and independent research houses little option but to keep most research behind paywalls. This will make it harder, if not impossible, to construct a market consensus, and calls into question the ability of companies to set and manage the perspectives and forecasts of the sell-side, which the market and financial media collectively relies upon to form a consensus view on company valuations.
Any company referencing “market expectations” in its communications will need to rethink what the term actually means in an environment where access becomes linked to ability to pay, and research notes become far less freely available or distributable. Indeed, the continued relevance of forecast aggregators such as Bloomberg and Reuters may even be called into question if these providers are unable to continue capturing a meaningful proportion of the relevant research that is generated under MiFID II rules.
IR professionals will find themselves with much greater responsibility, not just to drive investors to the research that best tells their corporate story but also to ensure that such research is written and published in an accessible way.
Accordingly, as MiFID II’s implementation looms, we believe companies must:
- Ensure that their in-house teams and external IR advisors are set up to evaluate and respond effectively to the challenges they face
- Estimate and set aside sufficient budgets to ensure that coverage and previous levels of market engagement can be maintained
- Identify the best and most influential independent and sell-side research providers in the new environment
- Start the conversation early with current key analysts about coverage – and the pre-requisites for initiating coverage – in the future
- Plan a coverage strategy in the immediate post-MiFID II world and be prepared to adapt and evolve that strategy as the effects of MiFID II become apparent and bedded in
The financial commentator Anthony Hilton deserves an honourable mention for being one of the few in the market to highlight the risks arising from MiFID II, writing in the Standard recently that it would be an “interesting unforeseen consequence” should it make markets much less friendly to listed companies in its effort to make them friendlier to investors.
While MiFID II will inevitably present challenges to companies, whether that ultimately makes markets less friendly to them will very much depend on the resolve of companies to protect their interests as listed entities and the actions they collectively take.