The Markets in Financial Instruments Directive (Mifid) rules may have already done permanent damage to investment markets, traders have warned.
The unbundling of research costs was a component of Mifid II rules, introduced a year ago, that was widely-acclaimed at its inception.
But Daniel Schlaepfer, president and chief executive of trading company Select Vantage Inc, said unbundling research costs has significantly damaged the quality of research and market competition.
Mr Schlaepfer said separating research costs from the price of execution was intended to give investors a clearer sense of what they were paying for.
Instead, he said it has forced fund managers to drastically cut their spending on research, most of them opting for a few larger research providers at the expense of independent specialists and smaller research firms.
Mr Schlaepfer, whose company can trade upwards of $3bn (£2.3bn) on global stock markets a day, said: "The current state of affairs is untenable. What we have seen in the last year shows that Mifid II goes too far and is too costly to implement.
"If the cost of regulation continues to grow unchecked, it will begin to defeat the very purpose for which it exists."
Michael Horan, head of trading for Pershing, part of BNY Mellon, said the rules requiring fund houses to pay for the research they receive from brokerages is having the effect of meaning smaller company shares are looked at much less by analysts.
As a result, Mr Horan said these smaller companies are traded less frequently, making the swings in share prices more pronounced.
Previously, many brokerage firms provided research on companies at no cost, in expectation of receiving commission buying or selling stock on behalf of fund houses.
Some of the largest firms in the industry, including Fidelity and Baillie Gifford announced that they would absorb the costs of research themselves, rather than pass it on to the end client.
He said: "The exodus of research analysts from the sell-side will continue into 2019.
"However, the more impactful trend to come out of research unbundling is the unintended consequence of reduced liquidity across small and mid-cap equity markets, because of lower company coverage on these types of stocks.
“Expenditure on small-cap research has decreased significantly, and coverage per company at the smaller end of the market has declined accordingly.
"The squeezed research houses are putting their efforts into the larger liquid stocks, rather than the lower-ticket small caps which are typically more difficult, and now more expensive, to analyse.
"This creates two problems: much lower liquidity at the smaller end of the market – which we are seeing already – and more capital into large-cap stocks.
"This, combined with the broader shift to passive investments and continued inflows into exchange traded funds (ETFs) and index tracker funds, is artificially increasing prices and causing investors to herd into large-caps.
"Lower liquidity in small and mid-caps has a number of potential implications.
"During periods of market volatility – such as the correction seen in Red October in 2018 – it makes it more difficult for traders and investors to unwind positions in what was previously a more liquid market, causing wider spreads and greater price swings.
"Over the longer term, a focus on large-cap indices from both research houses and investors means we could see a hit to smaller company initial public offerings (IPOs) due to a lack of investment appetite, meaning fundraising will need to come from other sources."
David Scott, an adviser at Andrews Gwynne in Leeds, said the rules are a major problem because many fund managers "do only basic work" on stock selection in the small cap part of the market.
Without analysts research, Mr Scott said fund houses will have less information to use when selecting a stock.
He said there could be an issue with liquidity as multi-cap investment managers, who have a choice between buying large cap stocks and smaller ones, are more likely to shun smaller companies as they require more work, at the same time that analysts research on companies diminishes.
Mr Scott said: "There are now small companies where the only analysis available is from the brokers, and because their job is to sell the shares they will always be positive, and of course that is not always useful."
david.thorpe@ft.com
