To say that the EU's Markets in Financial Instruments Directive II (Mifid) regime is suffering from ‘teething problems’ is an understatement. The problem is the rules as written are inherently ambiguous. No matter how carefully the documents are scrutinised – whether outside consultants are used or not – it is quite possible for different individuals within a firm to come to very different interpretations, let alone across the industry.
This may sound like an indictment, but it is not. Or rather it is par for the course when it comes to far-reaching regulations of this sort. Take the early days of the Market Abuse Regulation in 2016, which introduced the concept of ‘market soundings’ by an adviser when asking existing shareholders about a potential event for a company. This threw up a tonne of questions over what exactly counted as a market sounding. This was not a fatal flaw. Two years on and Market Abuse Regulation works well. The ambiguities were ironed out and a consensus emerged over time. Best practice when it comes to Mifid II will evolve in the same way, but it will take time and will not be achieved by simply referring back to the rules-as-written.
Then it was market soundings, now the tricky element is ‘inducement’ by an investment bank to an investor. What exactly does this cover? The question has wide-reaching implications. Take for instance a recent interaction between research house Jefferies and estate agency Purplebricks. Jefferies put out a damning sell note on Purplebricks, causing a price fall so sharp that Purplebricks felt compelled to put out an unscheduled trading update in response, specifically referencing the Jefferies note and contesting it with its own view.
Under the new rules only those who paid for Jefferies’ note should have seen it. However, Purplebricks’ response effectively made the contents of the note available to all. Does this mean all those who read the Purplebricks update were induced? And who is liable? To what extent should a firm be able to respond to such a note in this way? Not responding could lead investors to make poor decisions when research is not freely available.
Another thorny question is how to measure the value of unfamiliar research relationships. What if it is just one call a year, but the call is rumoured to be highly worthwhile? Similarly, is selling too cheaply or at a discount a form of inducement on the hope of commission via order flow? Is the regulator now in the business of policing fair pricing, and how will this work? Especially when the same content will inevitably be distributed to a number of institutions on different fee rates.
While these issues will be resolved over time, that does not mean there are not dangers – this could all have quite negative implications for market dynamics.
Everyone is currently having to review their existing contracts in light of the above considerations – contracts will now need to be highly specific, with a concrete and measured sense of who is getting precisely what and for how much. This could see the pricing landscape for research become very granular as individual elements are recognised and spun out, perhaps with models based on consumption rather than all-or-nothing.
This is not just about research notes. It covers calls, conferences (many of which used to be free to the buy-side), corporate access – all of these crucial elements of the buy-side/sell-side relationship raise questions about inducement and valuation. The relationship is about to become a lot more transactional, and – for most – more distant.
The unintended hazard of all this is that it could lead to smaller houses being effectively frozen out of the information system, unlike the few big behemoths that can simply afford everything.
Another big impact may be yet to emerge: research budgets remain tight and cutbacks on coverage from investment banks could result in a number of companies with only one or two analysts following. Should investor budgets not stretch to those investment banks, then liquidity could decline, widening spreads and ultimately hurting returns in large sectors of the market.
Unintended consequences are the hallmark of this sort of regulation and with Mifid II we will be seeing them for years to come.
Nick Burchett is UK equities manager at Cavendish Asset Management
