Europe’s magnum opus of financial market reform, the Markets in Financial Instruments Directive (MiFID 2), is set to go live at the start of 2018. It is a giant package of reforms designed to improve investor protections by extending regulatory oversight to previously unregulated asset classes, tightening rules around what products may be sold to whom, strengthening conflict of interest procedures, and boosting the overall transparency around costs, investment advice, and trade execution. It is easily the most complex piece of regulation global asset managers will face next year.
With only a few months to go before MiFID 2 is implemented, the industry still has a lot of work to do in terms of restructuring businesses, managing data, and developing technology solutions to prepare for the new rules. Brown Brothers Harriman (BBH) invited a panel of distinguished experts in the field to discuss how fund managers, advisors, and investors around the world may be affected by MiFID 2, and how they are preparing for the directive’s requirements.
Raising Professional Standards
MiFID 2 heralds a new dawn in the sale and distribution of financial instruments across the EU. Increased fee disclosures and Product Governance requirements mean more onerous compliance requirements for asset managers and distributors caught by MiFID 2.
Adrian Whelan, Senior Vice President of Regulatory Intelligence at BBH, reminded the panel that, for all its complexity and significant cost to implement, MiFID 2 is primarily intended to provide better protections to investors. He asked the panel what they consider to be the main benefits.
Carol L’Heveder, Head of Regulatory Affairs in Europe for the global investment firm Invesco, agreed. “From an asset manager’s perspective, and certainly as an active manager, we see benefits in the increased focus on transparency and net performance after costs and raising standards across the industry.” But she warned the challenges should not be underestimated because the changes are complex and there isn’t always a clear methodology for implementing them. For example, she said, “the industry needs to try to quickly develop market standards so that investors can evaluate comparable data.”
Bella Caridade-Ferreira, CEO of Fundscape, a UK-based research house that advises on asset management and fund distribution, said the increased level of transparency required by MiFID 2 also forces fund managers to shine a light into areas where they’re not particularly keen to do so. “For instance, they might focus on performance, but not necessarily on their trading costs. So this is going to be a push for them to answer whether they are doing the absolute best they can across the business.” She noted that this is one area where fund managers are slightly more resistant to change. “The firms that are going to do well after MiFID 2 are the ones that are moving with the times and starting to work on it now.”
Stuart Alexander, Co-Founder and Chief Executive of Gemini Investment Management, said MiFID 2 brings a better level of disclosure to consumers throughout Europe, along with the promise of aligning the motivations of product providers more closely with favorable investor outcomes. “When I began my career in this industry, sales and distribution were driven more by commissions than performance, and the costs were too high. There were far too many firms in the UK and Europe producing mediocre products and getting away with it by having a very aggressive sales force. Thankfully, we now have a more professional industry in the UK that is taking root across Europe.”
Can One Size Really Fit All?
The MiFID 2 requirements apply equally to firms regardless of their geographic footprint, size of assets managed, or staff. It has been criticized for the disproportionate impact the new requirements will have on smaller firms. In the past, other EU regulations, such as the European Market Infrastructure Regulation or the Alternative Investment Fund Managers Directive, have contained proportionality provisions.
BBH’s Whelan asked the panel how these changes, particularly the cost of implementing MiFID 2, will reshape the asset management industry.
L’Heveder said with MiFID 2 there will be a more level playing field. But, bringing transparency to costs linked to the manufacture and distribution of products will be a real change in Europe. Until now, and unlike in the UK post Retail Distribution Review (RDR), these charges have not generally been broken down for the benefit of consumers. “It’s going to be easier for the larger houses to comply with these requirements because either they have the infrastructure to deliver this transparency or they have the resources to acquire it,” said L’Heveder.
Aatif Ahmad, International Counsel for the law firm Debevoise & Plimpton LLP, highlighted the absence proportionality in the way MiFID 2 has been designed. “Regulators have come out with investor protection rules that are applied across the board, and with the Financial Conduct Authority (FCA) gold-plating them to include all investment managers and UCITS, there’s a danger they will also be applied in the institutional space.”
He also noted that MiFID 2 has been under debate and review since 2010. This time lag means the rules are slightly behind the curve in terms of more recent market innovations, making it more difficult for the industry to implement MiFID 2 in a technology-friendly way. “Not everybody can have big compliance and regulatory teams,” Ahmad said. “But the MiFID 2 rules do not offer borders around thresholds so smaller managers might be exempt from some of the more onerous requirements, such as reporting and unbundling, to allow them to continue to compete with the bigger players.”
Thinning the Herd
Certain MiFID 2 transparency requirements, like cost disclosures or unbundling of research costs, may make certain products more favorable to investors and distributors; as such this may narrow product distribution channels. Robert Rosenberg is Chief Operating Officer and Partner of Heptagon Capital, a private investment manager for high net worth individuals, family offices, and institutional investors. He believes the new rules favor the large investment firms at the expense of the smaller ones. “The large asset managers who have the resources and the technology in place today can absorb the cost of adhering to the rules, not just around fee transparency, but around trade reporting, research unbundling, and so on.”
By contrast, he said, the smaller players may have to review their business models and decide to consolidate, merge, or close up shop. This could have negative consequences for consumers. “Thinning the head may actually be a bad thing for the end investor because it could reduce the number of investment products they will have to choose from,” he said.
He also sees a lot of investors starting to focus more on the cost of investing rather than the returns. “A few investors we’ve had for a long time in other countries have been reluctant to invest in a fund because its total expense ratio is too high, even if it’s outperforming its peers. So, I think this focus on expense ratios can go too far and we need to focus on the ultimate goal — net return (after costs).”
Continued Bank Dominance?
BBH’s Whelan said that in terms of distribution, it is already clear that MiFID 2 adds complexity and cost to the role of advisors. The UK market is led primarily by Independent Financial Advisors (IFAs) and has been contending for some time with these distribution requirements in the wake of the UK’s Retail Distribution Review. On the European continent, however, distribution is bank-dominated. So will MiFID 2 push big banks towards even greater distribution dominance in Europe?
Caridade-Ferreira certainly thinks so. She expects that truly independent financial advice businesses in Europe, notably those that aren’t already tied to asset managers in some way, are likely to be killed off completely by MiFID 2 because they can’t survive the shift away from commission-based payment systems.
“These are small businesses,” she said, and they need scale to survive in this environment. Even in the UK, which Caridade-Ferreira noted is a 70% advice-led market, there’s been a lot of financial advice consolidation. “But if you take the Spanish market, where it’s less than 10% advice-led, how do you help those financial advisors move from a commission-based model where they’re getting that regular income to suddenly shift into a fee-based model and deal with customers who don’t want to pay them?”
L’Heveder agreed that big banks are likely to continue to dominate the continental market, adding that it is difficult to anticipate how their different distribution models will evolve. But she also agreed that under the MiFID 2 rules of inducement, bank-owned distribution channels should, in most cases, be able to continue to receive commission payments for their services.
In the UK, meanwhile, she noted that other changes would also have an impact, such as changes to client categorization rules and to the UK definition of investment advice, “so it’s going to be interesting to see what the combined effect of these changes will be.”
Gemini’s Alexander worries that “a rush to the bottom” will be the inevitable side effect of MiFID 2’s unswerving focus on cost transparency, and this will disproportionately impact fees across the industry. “It’s important to consider that, over the years, the actual overall fee to the end customer hasn’t changed,” he said. “Where it was cut — such as during the 1980s, when it went from 1.5% to 1% — there was a trail fee. When the platforms arrived in the late 1990s, they went from 1% to 0.75%, and that’s pretty much where it stayed. But then the passively managed funds came along and were generating great beta for 25 bps, so sorry global fund manager, you have to go from 0.75% to 0.25%.”
Regardless of a firm’s location, managers with EU-based financial instruments or EU-based trading counterparts, will have to comply with the MiFID 2 requirements. BBH’s Whelan asked the panel in what ways MiFID 2, a European regulation, will have global impact. Specifically, will it introduce any regulatory inconsistencies?
Invesco’s L’Heveder said that global managers are likely to encounter serious inconsistencies in many areas. “In Europe, the MiFID 2 approach to managing conflicts of interest in terms of research is to sever the link between trading and research costs so that you have to pay for research through a research payment account (RPA) or directly from your own funds. If you pay through an RPA, you can fund that cost through a commission-sharing agreement with your brokers or you can levy a separate charge on the client’s account, but in all cases, you pay for the research. These requirements create inconsistencies with other regulatory regimes.” For example, the MiFID 2 requirement that investment managers pay separately for research and execution services conflicts with the common US practice of bundling these services, which enables US brokers to aggregate orders for MiFID and non-MiFID accounts and avoid registration under the Investment Advisers Act.
She noted that this inconsistency would also adversely impact the ability of European managers to outsource certain investment or trading activities to firms outside Europe and select the most appropriate provider for their clients. For example, a non-EU firm managing assets for European asset managers would not have MiFID 2 type processes for evaluating the research it uses in managing those assets. A non-EU broker may not be able to receive payment from the EU investment firm for the research received by the latter.
“The unbundling requirements, as they stand, are too prescriptive and do not allow MiFID firms to operate globally in a way that is consistent with the rules that apply to their market counterparties,” said L’Heveder.
She expressed the hope that this, and other inconsistencies in the way the rules work, will be resolved through regulatory cooperation. Ideally, European portfolio managers will be able to use brokers wherever they are located, and pay fees in a manner that is both appropriate and compliant with both their and the brokers’ regulatory obligations.
Debevoise & Plimpton’s Ahmed believes that with regard to research unbundling, “the MiFID 2 rules kind of jumped the gun because in the UK we have already seen a move to the commission sharing agreement (CSA) model for paying for research and that has worked pretty well.”
Moreover, the banks that have been using the CSA model have been gaining market share, so there was already a trend in the UK — and spreading globally — for the research market to move towards a paid model through a commission sharing arrangement.
“It’s similar to the RPA,” he said. “But MiFID 2 is now creating an obligation for firms to have a hard RPA account to meet MiFID 2 requirements, without letting the industry develop on its own and evolve common practices globally, as with the CSA model. So, it’s creating this fragmentation where you must have a MiFID 2 compliance research payment account, and you have to use it to pay for research from a non-EU provider.”
Who Will Pay the Piper?
The new research unbundling requirements raise questions about how to pay separately for research that is currently priced as part of a bundled service — and how to stop research from being delivered as part of a package. This is particularly vexing for smaller managers, who may find that the demand for research declines sharply as investors realize it requires a separate payment from other services.
Heptagon’s Rosenberg warned that if his business can no longer charge the investor for its research and must pay for it out of the management fee, the cost will have to be absorbed someplace else.
But because MiFID 2 brings such a high level of transparency to costs, “the sophisticated clients will say ‘I don’t want to pay for your research anymore’ so it will have to come out of the management fee. There might be a general trend where we can no longer charge sophisticated investors for that research.”
At the end of the day, said Rosenberg, “it will really depend on your business models and your clientele. The market will determine where this business cost is going to end up.”
In his own business, where he works a lot with US-based asset managers, Rosenberg said, “we have to spend time, effort, and ultimately money to make sure everyone understands the rules and whether they apply.” He worries that many of these managers or sub-advisors outside of Europe may decide it’s not worth the trouble trying to raise money to enter the European market. “They may be happy to raise money in the Middle East, Asia, South America, the US – and European investors will lose access to those managers.”
Beyond January 2018
Looking beyond MiFID 2’s implementation, BBH’s Whelan asked each of the panelists to share what they believe will be the legacy of MiFID 2. Will it come to be viewed as the pinnacle of regulatory overreach or will the benefits ultimately justify the costs?
Fundscape’s Caridade-Ferreira noted that with every piece of legislation, there are always known and unknown consequences. “We probably haven’t seen half of them yet. My concerns around MiFID 2 are about how the potential absence of a level playing field will distort the market and push people into the wrong products and wrong funds — and therefore produce poorer investor outcomes.”
Invesco’s L’Heveder thinks MiFID 2 will ultimately produce a more level playing field across Europe, which along with the added transparency is good for the industry as a whole. “But overall, will the benefits outweigh the costs? Is this the last piece of European legislation that’s been dominated by the FCA’s past agendas, and with Brexit will we see a different framework and greater divergence? It makes for interesting times.”
Heptagon’s Rosenberg expressed strong doubts about whether MiFID 2 will fulfill its ambitious agenda. Without faulting its good intentions around investor protection, improving transparency, and reducing the potential for mis-selling, “I think all the unintended downstream ramifications are going to outweigh the good in the long run. Primarily, I foresee reduced product choice for investors and possibly more concentration into the larger market players.”
Debevoise & Plimpton’s Ahmed struck a similarly doubtful tone. “Five to ten years on, MiFID 2 will show the limits of regulation and how much regulation by itself can achieve.” He cited failing EU programs designed to promote investments in new technologies, small cap companies, and infrastructure as examples of the kind of regulatory overreach that MiFID 2 represents. “It didn’t lead to Silicon Valley in the EU, and I believe a similar fate will await MiFID 2 in terms of investor outcomes,” he warned.
Gemini’s Alexander suggested MiFID 2 will fundamentally change the landscape in which investment firms operate, both in Europe and globally. “We can expect to see a wave of business restructuring that includes consolidation or selling out of activities that will prove unprofitable in the future,” he said.
Some of the effects will be immediate, while others will take time to play out. We expect that certain impacts of MiFID 2 will only reveal themselves after the rules have gone live, and we can also predict that certain rules may be tweaked post-implementation but that the primary objectives of MiFID2 will remain.
A Darwinian Moment for Asset Management
What is clear is that asset managers of all shapes and sizes are now faced with significant challenges. As a matter of survival, they must adapt quickly, evolve their business models, and manage both the implementation and ongoing resource costs of meeting the requirements of the directive. MiFID 2 will change the EU asset management industry forever – those who can adapt to these seismic shifts can look to future success, while those incapable of change are likely to fade away.
How Will MiFID 2 Change Asset Management?
MiFID 2 is the most complex regulation global asset managers have ever faced and it will have far reaching implications for the industry. Adrian Whelan shares his predictions for what the asset management industry could look like post-MiFID 2.
A New Age for Trading
MiFID 2 heralds a new dawn for regulation of securities trading and governance measures for all market participants.
- The MiFID 2 Best Execution standards will become the global standard as regulators elsewhere push for greater transparency and better investor outcomes.
- Over-the-counter trading will reduce significantly as MiFID 2 forces trading into transparent exchanges.
Shift in Distribution Models
MiFID 2 will harmonize distribution and sales conduct across the EU. The new requirements will also significantly increase the obligations of financial product manufacturers to oversee those who sell products on their behalf.
- There will be a shift from the open architecture distribution model in Europe to a far more selective use of sub-distributors and intermediaries. Firms will rely more on in-house product sales teams and increase their direct-to-consumer offerings to ensure more efficient and cost-effective distribution chains.
- Inducement rules will increase the number of non-independent distributors selling a discrete suite of products rather selling broader product ranges.
Shining a Light on Value Proposition Through Price Transparency
MiFID 2’s harmonized cost disclosures will allow investors to make more accurate product comparisons and could propel the growth of more transparent products like exchange-traded funds (ETFs).
- Pricing and costs disclosures will highlight managers who provide investors with good performance, risk management, and general service. However, managers providing mediocre performance and service will not survive, resulting in significant improvements in the investor experience.
- ETFs will continue to grow in Europe as their level of transparency will match that of US ETFs.
Global Regulatory Fragmentation
Many regulatory concepts introduced under MiFID 2 do not exist globally. We anticipate that some non-EU trading jurisdictions may choose not to adopt the rules in an effort to make their location more attractive to asset managers. Others may choose to adopt them as best-of-breed policy.
- ESMA will pose more stringent standards for third countries wishing to avail of EU equivalence.
- SEC and ESMA will enhance coordination with one another to address regulatory conflicts recently witnessed in MiFID 2 Research Unbundling.
Data Protection Becomes Top Priority
Regulators are asking for an unprecedented amount of data. While the aggregation will increase transparency for investors and regulators, it will make it easier for nefarious forces to target, steal, or disrupt the flow of information.
- The case for permission-based decentralized ledgers, such as distributed ledger technology, becomes stronger to maintain and reconcile large data sets.
- In 2018, the asset management industry will enter a new era of enhanced data protection. Eventually the Global Data Protection Regulation will take over as top priority from MiFID 2.
Investment Research as an Efficiently Traded Commodity
MiFID 2 mandates a separation of trade execution and research costs, leading to more asset managers paying for research from their own resources.
- Up until now, research procurement costs have been largely opaque. The new research unbundling rules will make the market more transparent and efficient. As the market matures, research efficiencies will emerge where the most viewed research and its price will become fully discoverable.
- The MiFID 2 ban on free research obliges asset managers to make all trading decisions with brokers independent from the research they have received from that broker. This should decrease the volume of available research, but increase the quality of the research available.
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