The U.S. Securities and Exchange Commission's recent proposal to keep an existing exemption of domestic brokers from research payment requirements under the European MiFID II regulatory framework puts U.S. institutional investors at a disadvantage, according to experts.
MiFID II, or the second Markets in Financial Instruments Directive, requires sell-side firms, or broker/dealers, such as investment banks, to separate the cost of the research they are selling from the cost for their advisory services. On the other hand, buy-side firms, such as asset managers, are now required to pay for research directly rather than through commission revenues.
This unbundling of costs was not common practice before the framework was adopted in January 2018 and has led to considerable changes in Europe. Worried about the effects of the MiFID II rules in the U.S., the SEC issued no-action relief for U.S. brokers, which are exempt from the obligation under the MiFID II framework to register as investment advisers. However, it still allows them to charge separately for research they are selling to Europe-based investment firms.
Uneven playing field
The existing no-action relief was issued in October 2017 and will expire in July 2020. At the U.S. regulator's latest meeting on July 25, the SEC's investor advisory committee proposed to extend the no-action relief by three years, until July 2023.
The U.S. Securities Industry and Financial Markets Association welcomed the proposal, saying in an Aug. 2 letter to the SEC that an extension would provide more time to assess market developments, reassure market participants and prevent a blow to "investors, the U.S. capital markets, and the U.S. research marketplace."
Although the exemption protects sell-side firms and their investors from disruption, it does not provide relief for investors on the buy-side. Since the adoption of MiFID II, most European buy-side firms have decided to absorb the unbundled research costs rather than pass them on to investors. This is expected to result in considerable savings, with the U.K. Financial Conduct Authority in early 2019 estimating that investors in the U.K. will save around £1 billion in charges over five years due to MiFID II.
"The fact that part of the cost is now absorbed by fund managers does decrease costs for EU investors, putting U.S. investors at a disadvantage," Zhongwei Huang, an assistant professor in accounting at the Cass Business School in London said in an emailed comment.
Some U.S. fund managers have responded to investor concerns and have opted to absorb global research costs rather than just EU research costs, Zhongwei said.
Furthermore, the MiFID II rules require buy-side firms to disclose their research spending and justify the costs and value of the research. U.S. buy-side firms are currently under no such obligation and their investors have limited access to research spending information.
Call for transparency
In June, the Council of Institutional Investors, an organization representing 135 U.S.-based companies, including the country's largest pension fund, the California Public Employees' Retirement System, called on the SEC to make investment research disclosure mandatory for U.S. fund managers, according the Financial Times. The CII raised concerns that without transparency, U.S. institutional investors could pay for research used by fund managers in Europe, the FT reported.
Market observers have also highlighted problems related to the imbalance in U.S. and European rules as a result of the implementation of MiFID II.
"U.S. investors are paying for research without being shown the costs of that research while European investors have that transparency," investment management technology firm Red Deer said in a recent analysis.
U.S.-based asset managers may face competitive pressure to comply with MiFID II rules despite their slow adoption in the U.S., according to Bovill, a financial services regulatory consultancy. As clients come to expect a higher level of transparency under MiFID II, U.S. asset managers that do not adhere to the rules would be disadvantaged when competing for mandates against European investment firms, the consultancy said.
MiFID II risks
However, there are also arguments in favor of the extended exemption given that the MiFID II rules have brought on sweeping changes for investment research buyers and sellers in Europe. In a recent study, Cass Business School found that 334 Europe-based companies have lost sell-side analyst coverage completely as a result of MiFID II. Smaller firms are more affected by the loss of coverage, which is among the main reasons the U.S. has been wary of adopting the full MiFID II framework.
On July 9, the U.S. House of Representatives passed a bipartisan bill requiring the SEC to study the provision of investment research for small issuers. One of the key issues in the study is the examination of different payment methods for investment research and how these change the focus of research.
The Cass Business School study, published August 21, said that available sell-side research has shrunk while buy-side firms have increased their in-house research capabilities. MiFID II represented a shake-up of traditional business practices in Europe and is likely to have a similar effect in the U.S., according to Zhongwei.
"If I am to speculate, I would say that the impact on the availability of research could be stronger in the U.S. given that U.S. has more independent research providers, and independent research firms might struggle more than the full-service providers after the research cost unbundling," he told S&P Global Market Intelligence.
