Some see dire consequences ahead, fear liquidity crunch
Money managers and other industry representatives are divided on the impact the incoming Markets in Financial Instruments Directive II will have on bond research and liquidity.
The rules, known as MiFID II, come into play Jan. 3 and, among other things, will require all financial firms doing business in the European Union to disclose research costs as a distinct line item, unbundling them from execution payments. Another part of the rules will enhance pre- and post-trade reporting requirements.
While much has been said of the impact of MiFID II on the equities market, some executives working at money management firms and industry associations feel less has been covered regarding the impact on fixed-income markets — but that there could be far-reaching consequences in terms of the level of research available and, potentially, liquidity.
Speaking at Pensions & Investments' WorldPensionSummit in The Hague, Netherlands, last month, Jack Inglis, CEO at the Alternative Investment Managers Association, London, voiced his concerns over MiFID II. "The impact on the market is there's going to be less research. I think we're most likely to see the impact in fixed-income research," he said, citing surveys showing about a 66% reduction in the production of fixed-income research going forward. "So all this means there's less rigorous original thought in the marketplace for the investment process, and I would suggest that may be a problem."
Sources at other organizations and money managers agreed there might be far-reaching effects on certain areas of fixed-income research.
"Where asset managers will need research in fixed income might be in areas that could see a shortfall after this change because of unbundling and broker-dealers not providing" research, said Patrik Karlsson, director, market practice and regulatory policy at the International Capital Market Association and secretary of its Asset Management and Investors' Council in London. "If you are running an actively managed fund, you will want to provide alpha and want to pay for the inputs to your fund that create alpha. Where that is more valuable (may be) high yield, (collateralized loan obligations, residential mortgage-backed securities), covered bonds, emerging markets — not necessarily your vanilla corporate bonds from large issuers."
There might be unintended consequences for new issues, off-the-run names and research of smaller companies, where coverage of the market is likely to decrease said Mark Wade, London-based head of industrials and utilities research at Allianz Global Investors.
"That means that the views circulating are more restricted, it means that when something bad happens or somebody goes to sell a block of bonds, the ability for somebody to go out and explain that to the market, and for that risk to be distributed freely and without impact on market pricing, is compromised. The less research we have out there circulating, the more vulnerable the market is to spurious comments, speculation and research. That is something that, on the wrong day … has an impact on liquidity and market pricing," said Mr. Wade.
BlueBay Asset Management's Spencer Woodward, director of investment operations in London, said the firm expects a "mixed reaction to research availability. Most of the banks we have spoken to will continue to provide research, but we may see a longer-term decline depending on how the economics work out."
But there are nuances in the research-related impact.
"Within the fixed-income space there is a lot of macroeconomic research," Mr. Karlsson said, noting that guidance from the European Securities and Markets Authority says some macroeconomic research can still be free as a minor, non-monetary benefit — the term for something that isn't research as an inducement.
This type of research cannot be specific to an investment strategy, "but if it is just market color about interest rates, etc., it can be free."
There is also the potential for enhanced in-house analysis and independent providers of research to step into the void left by banks.
Gary Kirk, London-based partner and portfolio manager on TwentyFour Asset Management LLP's Strategic Income Fund, said the impact of MiFID II on fixed-income research availability will not be as bad as first anticipated.
"The overall charge from the key research suppliers has gradually reduced from the initial levels indicated when the MiFID II rules were announced. End-users will obviously have to select the research from those houses they believe produce the best quality, and hence the volumes received and used will generally reduce; but the overall level of quality information available to investment professionals is not expected to be diluted," said Mr. Kirk.
The incoming rules have led money managers to make a number of moves. Some have increased their in-house research capabilities, bringing analysts on board to help deepen and broaden their own work. Others have conducted analysis of the research they source externally from banks and broker-dealers, which has helped them to make decisions on their future use of this research. And in terms of compliance with the rules, many have publicly announced their intention to foot the bill for the external research they use, rather than passing on the cost to their clients.
Developments in U.S.
There have also been developments in the U.S. related to MiFID II. The Securities and Exchange Commission last month issued guidance stating U.S. money managers will be allowed to unbundle research and execution costs and not violate their fiduciary duty.
"One of the more vexed issues is the treatment and definition of investment research," said Julian Allen-Ellis, London-based director at the Association for Financial Markets in Europe. "We've achieved a significant win on the provision of research from third countries into Europe, which was a big problem."
"Firms should note that similar issues may persist with regard to other third-country jurisdictions, with respect of being able to accept unbundled commissions and payments for research. AFME is monitoring those issues and plans to addresses them to the EU Commission at an appropriate time," added Mr. Allen-Ellis.
He said the way the research market is shaping up is interesting, with discussions ongoing about models, price points and engagement. "The market will find its own level but that's not going to be a painless process."
From an industry point of view, the biggest losers are likely to be the smaller money managers that do not have in-house research, said sources. "They will have higher costs and potentially a narrower range of research available to them," said Chris Perryman, head of trading, emerging markets fixed income at PineBridge Investments in London. "Typically (managers) will slim down the lists of research they buy and consume from banks."
And Mr. Perryman said there will be a big difference in the attitudes and reactions in the first year, where managers "are looking to satisfy the MiFID II rules, and further down the line, say year three, where everyone will be more comfortable in quantifying and qualifying their use and buying of research. ... For fixed income, we are starting from a point where it's always cost zero, and therefore now introducing a cost means it is harder to calculate."
Mr. Karlsson agreed there might be an impact on smaller money managers using the profit and loss to pay for research, "as larger firms will have bigger capacity to absorb costs initially."