Four fundamentals of MiFID II
MiFID II came into force in January 2018 and could well be the biggest change in the capital markets since Big Bang in 1986. Matthew O'Keeffe outlines four key features of the new regulation.
1. It’s a European law
MiFID II is a piece of European Commission legislation relating to commissions paid on share transactions. This is of huge interest to anyone who works in the square mile as secondary commission is very lucrative for research analysts.
Payment for research by fund managers has, traditionally, been bundled up with the cost of trading (among other costs) and paid for out of the fund managers’ funds. The EC has two objections to these arrangements on the grounds that they are both opaque and improper.
2. Current practice is neither transparent nor proper
Payment for research is said to be opaque because it is bundled up with payments for other services provided by the brokers e.g. the cost of trading. This is not an unreasonable objection and the very fact that the brokers themselves employ hundreds of people across the City with the task purely of disentangling/allocating commission internally (and rewarding their own employees appropriately) would seem to support the EC in this objection.
The more fundamental objection, however, is to do with ownership. Commission is paid for out of the fund manager’s funds rather than out of his own P&L which means that it is the end customer who pays ultimately for commissions. Of course, the buy-side is a competitive world and competition between funds should (in theory, at least) discourage any one manager squandering all his assets on the commission paid to his brokers.
Moreover, the arrangements are certainly well understood in the City (and probably well understood by anyone who entrusts serious money to an institutional investor). But these and other defences have fallen on deaf ears; the principle of caveat emptor has been abandoned in favour of a more interventionist approach.
Because research payments are opaque and, more fundamentally, because the fund manager does not pay with their own money it is assumed that thy do not care too much about the price of research. The EC has further concluded that the payments are too high and represent a cosy arrangement whereby brokers and fund managers enrich themselves at the expense of the end customer.
3. Payment for research by bundled commission is now illegal
The truly bold proposal of MiFID II is that payment for research by bundled commission is now illegal. Fund managers now pay for research from brokers in one of two ways:
- they can pay in cash from their own P&L accounts or
- they can make use of a Research Payment Account (“RPA”) to be set up with their own end customers.
The RPA is an agreement through which the end customer explicitly agrees not only to management fees but also to a set amount for broker research. However, implementing either of these alternative arrangements will be easier said than done.
The new RPAs are likely to prove unpopular with the end customers as they represent yet another layer of expenses on top of the normal management fees charged by institutional investors.
Paying for research directly will prove unpopular with institutional investors who have been able to receive it free (at least at the point of use) for the last 30 years. The larger fund managers may well be able to pay for their research directly, but for the smaller fund managers the incremental costs may well be the difference between life and death.
4. Payments for research are likely to fall dramatically.
Nobody knows how far they will fall because there are very few precedents. The regulatory impact of Big Bang in 1986 (which is arguably the last change of comparable significance) saw commission rates fall from 45 bps to 25 bps i.e. a reduction of 45% in price.
Commissions today are considerably lower: the more generous investors today might pay 15 bps where the more mean investors might pay as little as 8 bps. But, low as they are, it is hard to see how these commissions can hold up given the difficulties the brokers will face as they try to introduce direct charges for research and given, too, the difficulties which the fund managers will face as they try to introduce RPAs to their end customers.