MiFID II unbundling review raises concerns

Just when money managers across the globe thought they had dealt with European trading rules, new suggestions to alleviate a perceived decline in smaller company research and investment are threatening to cause further upheaval.

On Feb. 17, the European Commission published a public consultation on the review of the Markets in Financial Instruments Directive II. The rules, which came into effect Jan. 3, 2018, brought in a set of requirements to improve transparency in trading.

For money managers, perhaps the most discussed and burdensome of the requirements was the mandatory separation of payments for investment research and the execution of trades. Managers largely decided to absorb the costs of research on companies themselves, rather than passing them onto clients.

Now, the commission is suggesting that these MiFID rules be amended to effectively rebundle payments for certain companies.

Sources in the money management industry had already expressed concern that MiFID II and the so-called unbundling would have a detrimental effect on the quality, quantity and focus of investment research.

And now, it seems the European Commission shares that concern when it comes to small and medium-size enterprises, which it said over the recent years has suffered in terms of research coverage.

"One alleged reason for this decline is the introduction of the unbundling rules," the commission wrote. "Less coverage of SMEs may lead to less SME investments, less secondary trading liquidity and less (initial public offerings) on (the European) Union's financial markets."

The commission added: "There is a need to consider what can be done to increase (SME research) production, facilitate its dissemination and improve its quality." The commission wants responses to its consultation and suggestions from all parts of the financial services industry by April 4.And while money managers were never particularly pleased to see MiFID II's unbundling rules come in, they said the rules were not solely to blame for the demise of SME research.

"The overall suggestion appears to be that MiFID II's unbundling rules are behind the decline in research coverage for SMEs — I think that may be partially true, but there are other far greater forces at work here," said Eoin Murray, head of investment at the international business of Federated Hermes Inc. in London. These forces include "the relentless drive to passive as investors continue to focus on fee/value for money," since much of passive indexing does not allocate capital to smaller companies.

Anthony "Tony" Dalwood, CEO at Gresham House PLC, agreed. "Before MiFID II came along, there were issues around capital access for smaller companies. Institutional capital for smaller companies has been declining for over 10 years, and for many reasons: One explanation is that the size threshold hurdle for smaller companies has increased. Some investment managers have small companies defined as below £2 billion market cap — we're talking about companies at the top end of the FTSE 250," he said. This increased threshold means few investors look at the small-company universe because they are not allowed to due to constraints such as liquidity, the ability to sell quickly and the ability to invest enough in a company in order to achieve a target weighting in their portfolio.

These issues have manifested in a halving of the number of small companies listed on U.K. and U.S. stock exchanges over the past 10 to 15 years, he added.

"Then MiFID II comes along, and regardless of the extent that it has reduced SME research, and institutional capital access for smaller companies, at the very least it has not helped, at the most it has accelerated that situation — leaving small companies crying out for more engagement from properly active investment managers," Mr. Dalwood said.

While the extent to which unbundling rules are to blame for the demise of SME research can be disputed, sources agree that something needs to be done.

The suggestion that MiFID II's unbundling rules be reversed for SME coverage was met with concern that any moves may lead to further negative consequences.

"The original rules came with some seemingly unintended consequences, but I think it would be a danger to consider exempting some parts of the market from those rules, as that will only create further unintended consequences," Mr. Murray said.

The definition of SME itself would be one area for potential problems.

"What threshold would you apply to SMEs? To some (investors) SMEs would be an entirely private market, and to some it would be smaller issuers," said Mark Wade, director of research industrials, global fixed income at Allianz Global Investors in London.

An exemption might only help at the margin.

"The reason I say that is because an SME's bond size is going to be small. Even if we know a company, irrespective of whether there's research or not out there, there are liquidity constraints. For some of the bigger players, (the bond issue and opportunity) is almost too small, as there is an administrative and liquidity headache," he said.

What may be more helpful to alleviate any lack of coverage or investment in SMEs is to look at the transparency of smaller firms in the first place. "If you're a big company you either publish very detailed … SEC filings or reports. The smaller you go, typically the weaker the disclosure. We face challenges like password-protected websites. So again, if research were to be complemented by a broader-brush push for more open disclosure, then that would be beneficial," Mr. Wade said.

Whether the issue of declining research is alleviated by exempting research on certain companies from the rules, sources doubt money managers — which have spent considerable time, effort and millions of dollars on altering processes, systems and relationships in order to comply with MiFID II in the first place — would be keen to reverse their hard work.

"Unfortunately, the die has been cast and asset managers have spent a huge amount of time dealing with the implementation of MiFID II and what it means across multiple levels of the firm," said Steven Fine, CEO at Peel Hunt LLP, a London-based corporate broking, advisory and trading firm focusing on small- and midcap companies. "As a consequence, if they have significantly changed their mechanisms for commissions and payments, it is unlikely they are going to go through the hassle and rigmarole to change it back just for smaller companies."

He said it is "great that they want to review the MiFID framework, and it's great (the EC has) got some ideas on what to do, and that they believe there are some ways around it. But I am very skeptical whether it will make a material difference."