This question is often posed to Brexiteers, usually by those who believe Eurosceptics lack detailed arguments or, worse still, didn’t know precisely what they were voting for. Though this may be true in some cases, EU-friendly commentators are also, at times, guilty of a myopia of their own – assuming that the current regulatory status quo automatically equates to ‘best practice.’
In reality, the European Union has been responsible for a raft of regulations which have caused great harm to businesses and consumers. While much is made of the business compliance cost of certain regulations, less attention is generally paid to the anti-competitive harm they cause. Increasing costs for certain firms, and forcing some (especially smaller, firms) to exit the market can have the effect of raising prices for consumers and diminishing capacity. Anti-competitive regulations make it difficult for new competitors to enter the market, thereby entrenching existing companies and leading to the formation of oligopolies.
In the coming weeks, we will be examining a series of regulations with anti-competitive effects to illustrate how they work and the harm they cause.
Part 2 – Un-bundled Research
As discussed last week, the Markets in Financial Instruments Directive (Mifid II) brought sweeping changes to the EU’s finance sector when implemented in January 2018.
One of its more controversial changes has been to require investors to pay directly for research – known as “Unbundled research” – from brokers and investment banks. From now on, such fees will be covered either by the end client, or out-of-pocket by investment managers. This represents a major shift from previous practice whereby research would be provided as part of a bundle of services, carrying no explicit charge.
What was the goal of the regulation?
Presumably, the regulatory goal was to protect consumers. ESMA – the European Securities and Markets Authority – were apparently concerned that free, unsolicited research could be viewed as an inducement to trade. But does anyone seriously believe this? We might consider things like swanky lunch invitations, Wimbledon tickets, private boxes at football matches, Glyndebourne tickets, ski weekends, and so on, as inducements to trade. Research reports, however, require great effort and thought – both to read and produce – and may not convince an investor to follow the recommendation of the analyst or even to trade at all.
Was this regulation ever necessary?
Probably not, given that MiFID II research payment requirements do not cover UCITS (the EU’s regulatory framework for retail investment vehicles) funds in the EU27, but have been applied to UK-managed UCITS funds by the FCA. As a UCITS fund is a retail investment fund, i.e. something that can be bought by a “man on the street” or non financial professional, this makes the regulation doubly damning. If any fund should be free from inducement it ought to be be a retail fund.
Prior to MiFID II, investors could receive research reports on a company or industry sector from many different brokers, read them, compare their conclusions, and decide whether to trade using the broker of their choice. The system worked. There was no requirement to trade if the investor was not convinced by the research.
Why is un-bundled research anti-competitive?
Firstly, it will reduce the research available on smaller, less traded or new companies. This has been acknowledged by the regulators as a potential problem. Over time the profit motive will encourage financial analysts to move their coverage to larger companies with greater trading volumes as these will provide the greatest return for the analysts’ products. Even large investment banks will not be able to cover every SME and start-up and so will cover the companies that the majority of their customers are interested in, pushing investment towards these companies and away from SME and start-up companies. This will carry harmful economic consequences. Dynamic economies should encourage new firms to be established and small companies to grow in order to keep the market vibrant, promoting growth and innovation and challenging incumbent advantages.
Secondly, the new rules will reduce the number of small or independent research firms by reducing their ability to compete with the large international investment firms. It has been reported by Bloomberg and others that JPMorgan Chase are offering access to all of their worldwide research for an annual fee of just US $10,000 – a price level that will be extremely profitable if all of their 60,000 global clients are prepared to subscribe to it, but at the same time, cheap enough that smaller local research companies offering research on only a single market or with only a few clients, will not possibly be able compete. If other large multinational firms follow JPMorgan’s lead, then it could lead to smaller, independent research companies being wiped out altogether – thereby reducing competition in the research market.
But that’s not the end of the story. From now on, local independent researchers will certainly need to convince their clients that they are providing higher quality research or an independent perspective if they are to survive. However, MiFID II also stipulates that research be “substantive” – a factor usually measured by volume of research, rather than by quality. This, of course, plays further into the hands of large research companies and incumbents, who have a much higher output. Conducting these assessments based on quality could have given independent providers an opportunity to differentiate themselves and compete on a level-playing field. As it is, MiFID’s “Unbundled Research” regulations represent a huge missed opportunity.
Read Part 1 – MiFID II – here.