A proposal by the EU to amend new financial markets rules raises questions about regulatory divergence from the U.K. and may create more complexity for investment banks and asset managers.
On July 24, the European Commission proposed simplifying rules around securitization and investor prospectuses and changing elements of the Markets in Financial Instruments Directive, or MiFID II, such as the price unbundling of investment research. The move is aimed at driving more investment in an EU economy that has been shaken by the coronavirus.
The proposals and an expected wider review of the MiFID II framework in 2020 are spearheaded by the EU only, with no clarity whether the U.K. will adopt any changes to the original MiFID II rules. Britain is set to complete its exit from the EU on Jan. 1, 2021, after the transition period ends.
The U.K.'s Financial Conduct Authority was not involved in the discussions leading to the EC's proposals and will not take part in the legislative process to discuss and revise them, a source close to the regulator told S&P Global Market Intelligence.
Potential for future divergence
The EC is considering exempting SME stocks' and fixed-income research from the cost unbundling requirement under MiFID II, meaning asset managers would no longer have to pay for such research separately.
This unbundling requirement controversially altered a long-standing practice of sell-side firms, such as investment banks, whereby they bundled together the fees they charged buy-side companies, such as asset managers, for research and execution. It rocked the research market as sell-side firms struggled to find the right pricing and buy-side firms cut research budgets by as much as 30%, according to estimates by the U.K.'s Financial Conduct Authority.
The topic of unbundling was not received with the same enthusiasm on the continent as it was in the U.K., Michael Huertas, a partner and co-head of the financial institutions regulatory unit at global law firm Dentons, said in an interview.
The FCA concluded that asset managers in Britain have sufficient access to research and that unbundling has not led to a material reduction in research coverage for U.K.-listed SMEs. But in the EU research coverage of SMEs has decreased, making it more difficult for such companies to raise capital, Holger Schelling, a Frankfurt-based partner at Dentons said in an interview. A Cass Business School study in 2019 found that 334 Europe-based companies have lost sell-side analyst coverage completely as a result of MiFID II.
The EC proposal aims to ensure SMEs get enough analysis so investors can support "what is the backbone of the European economy," Huertas said. "Policymakers will throw everything at that."
It is not clear whether the U.K. will change the MiFID II regime. The FCA was a strong supporter, and to some extent a driver, of the research rules in MiFID II, so the U.K. is not likely to move too far away from the original requirements, Michael McKee, a partner at global law firm DLA Piper, said in an interview. But it may follow the EU in liberalizing the fixed-income and SME research rules.
Changes to unbundling rules will likely create more complexity for both sell-side and buy-side firms because they will have to comply with different rules across jurisdictions and may need to change existing research pricing and payment schemes.
It may give different member states more optionality about whether they apply the revised rules or not, and it is not clear which companies would take advantage of the liberalization and which would not, McKee said.
"The situation would create more complications for investment banks if they have to change what they have already put in place to comply with MiFID II for certain countries," he said.
Moreover, it is doubtful whether buy-side firms "which have been very conscious and careful about applying MiFID II correctly and obviously went to paying for research from their own pocket" are going to "unscramble" their research payment schemes, Steve Kelly, a special adviser at the European Association of Independent Research Providers, said in an interview.
"For international fund managers and providers of research, the rule change in the EU will create more complexity," he said.
As a non-EU member state, Britain needs an equivalence agreement with the EU for continued access to the bloc's single market. With negotiations ongoing, U.K.-based financial services providers are in limbo regarding their business with EU clients from 2021.
A decision on the equivalence between the EU and the U.K. should be made within the next year, McKee said. If the EU takes the view that the U.K. is not equivalent, it will be a purely political decision, he said.
If the EU denies the U.K. equivalence, the latter will likely use the ensuing flexibility to become a more attractive place to do business within the global regulatory standards," McKee said. This will not mean a regulatory race to the bottom, but rather that the U.K. will not be "shackled" by some of the heavier requirements that are imposed quite often at the EU level, he said.
"Operationally, regulators would like to stick close together [post-Brexit] but politically that might not be possible. This is more and more going to become a political football between the EU and the U.K.," Kelly said.