Unexpected but welcome surprise
Anyone can agree that 2020 has been a year that is far from usual. The onset of the novel coronavirus pandemic has shown that this year will live on in the memory, regardless of how it concludes. The negative effects of the pandemic will also hang over the global economy. In terms of policy responses, action has been swift and significant from governments and regulators. Recently, one of the more surprising responses to aid economic recovery was announced in the EU, with plans to rollback elements of the Markets in Financial Instruments Directive (MIFID 2) to help with the continued funding of EU companies particularly smaller firms and debt funding through bond issuances.
In the wake of the pandemic-induced economic crisis, all manner of economic support and stimulus programs have been implemented. Evidently, the crisis requires a reduction in any unnecessary burdens and restrictions to facilitate trading activity needed to foster economic recovery, however, very few would have predicted the EU would target a roll back of MIFID rules as a recovery tool. MIFID 2, of course, is a foundational regulation of the EU capital markets and spans and reaches every corner of EU asset management, therefore even temporary targeted relief can have a substantial positive impact to EU asset managers.
The comments by Valdis Dombrovskis, European Commission Executive Vice President, on the proposals are compelling and show the effect that tailored regulations can have on capital markets:
“One way of doing so is to help businesses raise capital on public markets…..Today’s targeted amendments will make it easier for our businesses to get the funding they need and to invest in our economy. Capital markets are vital to the recovery, because public financing alone will not be enough to get our economies back on track.”
The MIFID changes are deemed necessary as Europe looks to recapitalize the real economy, particularly small and medium enterprises (SMEs) and looks to stimulate equity funding and not be solely reliant on debt funding for businesses. The two targeted MIFID provisions proposed to be temporarily scaled back are:
- Research Unbundling
- Best Execution Reporting
As a quick reminder, MIFID 2 demands that asset managers must pay banks and brokerages for investment research wholly separately from their trading fees, in what is generally referred to as “Research Unbundling.” This separation of the cost of research from trading commissions was imposed to reduce inducements and conflicts of interest between asset managers and brokers. Critics of unbundling suggest that it has reduced the availability and quality of available research, particularly for smaller capitalization stocks and the result is that smaller firms have subsequently struggled to attract investors and reduced market liquidity in such stocks. SMEs particularly need a good level of investment research to give them enough visibility to attract new investors, since they are often not well-known brand names. It has been suggested that asset managers’ research spending has reduced by up to 30 percent, spurring a price war between banks and independent research providers to sell research (an intended consequence), however, this also resulted in a big decline in research coverage of small-cap companies (an unintended consequence).
The other common cited criticism of unbundling is that it does not work for bond trading where the cost of trading is covered by spreads rather than commissions. Interestingly, this unbundling issue was already subject to an ongoing MIFID consultation where industry had strongly advocated for permanent removal of the unbundling rules.
Under the European Commission proposals, firms would be allowed to “re-bundle” research and trading costs for all fixed income trading (allowing all rates, credit, and loan research to be bundled) and for equities for all companies with a market capitalization of less than €1 billion (c.$1.15 billion).
MIFID 2 best-execution reports require that each trading and execution venue for other financial instruments publicly disclose data on the quality of transaction execution periodically. The detailed reports include details about trade price, costs, speed, and likelihood of execution for each trade. It’s a significant data aggregation and reporting burden, and industry believe that despite the huge volume of data disclosed, the reports are rarely read by investors, a point empirically proven by the very low numbers of downloads from the website where the reports can be found. Further, the Commission notes that 70% of respondents to the recent ESMA MIFID 2 review consultation indicated that the best execution reports are not useful.
Asset managers simply don’t rely on these regulatory reports either as they directly engage with their trading counterparts on best execution standards. ESMA had previously deprioritized the publication of these reports anyway to alleviate some burdens on asset managers in the context of the pandemic. This proposal just looks to extend this suspension and with the full review of MIFID 2 planned in 2021 anyway, we could see a permanent removal of these reports in due course.
Isn’t it ironic, don’t you think?
As usual, the Commissions’ proposal requires further approval by the parliament and Council but is likely to become effective in early 2021. These rollbacks are very intriguing targeted relief to assist the European capital markets. They also contain a large degree of irony. The looser ruleset will become effective early in 2021, after the United Kingdom has left the EU due to Brexit. The logic of Brexit was to remove certain unnecessary regulatory and operational burdens to allow business flourish, however, UK asset managers may be left with both unbundling and the reporting regimes under FCA rules and will not be able to directly avail of the EU relaxations. US managers have long urged the EU to solve for the unbundling anomaly, and while they will be pleased to see this proposal, they will also likely be uttering the occasional, “I told you so!”