The European Commission (EC), through the European Securities and Markets Authority (ESMA), is close to putting its final touches on MiFID II, the pan-European regulation designed to promote competition in the investment marketplace, while offering greater transparency and protection to the investing public.
As this process draws to a close, the EC is in danger of forever damaging Europes flow of investment research, the lifeblood of portfolio managers and analysts and the engine of investment performance.
How did this happen? The problem hangs on a small section of ESMAs Technical Advice that considers research to be an impermissible inducement, and thus, a conflict of interest. The UKs Financial Conduct Authority (FCA) has led the charge on this issue, most recently in its feedback to ESMAs final Technical Advice to the Commission.
The FCA insists that there is no middle ground to address this conflict; it simply cannot be managed. It has suggested, in the face of much industry dissent, that the only solution lies in eliminating the use of commissions to acquire research and moving to a hard dollar research market. In the opinion of many, this is a solution in search of a problem; one that will create a number of new, unintended consequences. (Not only a reduction in all research, but a flight by investment managers to markets with a more sensible regulatory framework, and a remaining European financial market of fewer, larger players on both the buy and sell-side, reducing competition.)
In our recent comments to the European Commissionwe pointed out that Commission Sharing Arrangements (CSAs) already provide the necessary framework to address the concerns of regulators. CSAs provide a framework that uncouples turnover from research valuation – a key concern as to why this conflict of interest exists. CSAs also provide a granular accounting of both the costs of research and execution, as well as transparency for investors.
With the use of CSAs established almost a decade ago, we have seen a tremendous growth in both the amount and variety of independent research available to investment managers, all of which is obtainable through the same process that enables an investment manager to acquire sell-side research.
Ironically, in the past, the FCA has been largely pleased with the manner in which CSAs have proved successful in meeting its needs. Only recently has the FCA decided that CSAs cannot completely address all of its concerns.
Yet no industry is without its conflicts of interest and no regulation is perfect. The goal of regulation is to balance the management of conflicts — not eliminate them — against the necessary investor safeguards without imposing needless costs and the stifling of competition and job creation.
The Wall Street Journal recently quoted Lloyd Blankfein, CEO of Goldman Sachs on this issue. More intense regulatory and technology requirements have raised the barriers to entry higher than any other time in modern history…only a handful of players will likely be able to effectively compete on a global basis.
To quote Neil Dwane, chief investment officer of European equities at Allianz Global Investors, commenting on how the proposed rule changes are prompting large investment managers to reassess what research is worth buying; Investment banks think the asset managers will just pay for [everything]. The [numbers] of that just dont work.
From Nick Anderson, head of equities research at Henderson Global Investors; We are working to change the mind-set so that fund managers understand that research should be treated as a scarce resource.
Do we really want investment managers trying to limit the amount of research they use in an effort to keep their costs down? What major pension plan wants to allocate money to an investment manager whose goal is to use less research? And why would an asset allocator choose an investment manager operating under such a restrictive rule set?
Eliminating the use of commissions to acquire research would likely mean that there will be less research available in Europe, and from fewer players. All at a time when the majority of the growth and innovation in research is coming from independent research firms, whose lifeblood relies on the flow of commissions. This is not good for the financial industry or the investing public.
In addition to helping new sources of research flourish, the use of commissions has enabled small investment managers and brokers to compete on a level playing field with their larger counterparts and has provided a natural subsidy, where larger investment management firms produce more in brokerage commissions, smaller firms less, and brokers and independent research firms can thrive. The use of commissions has created an equilibrium, of sorts, that has worked well for over forty years.
New regulation should support the use of CSAs to help provide further transparency for investors, continuing the use of commissions as a currency of exchange in the financial markets. We have a system that works well and managing any remaining conflicts of interest should be done with a careful touch so as to not throw out the baby with the bath water.
The time to speak up is now. Industry players and other leading voices in the EU need to make it clear that the proposed rules, in their current form, will destroy a vibrant research marketplace, stifle competition and leave investors with less choice.
This would truly be missing the forest for the trees.
Tim O’Halloran isCo-President ofWestminsterResearch Associates,a ConvergEx company
