Coming soon, maybe: splitting research from trading

Big super funds tend to take comfort in the knowledge their international fund managers and global custodians will satisfy requirements in relation to new European regulations – and there are a lot of them – without too much fuss or flow-on costs. But MiFID II may hit home more directly than they think. And some of the directives may go global.

The second Markets in Financial Instruments Directive (MiFID II) takes effect next January. One of its central directives, which has been spoken about a lot in Australia and the US over the years without much disruption to the current system, is the separation of research from execution.

The high-level goals of MiFID II are: increased transparency of markets; a shift in trading towards more structured marketplaces; lower cost market data; improved best execution; orderly trading behaviour within markets; and, more explicit costs of trading and investing.

According to Tony Freeman, the executive director of global industry relations for DTCC, the industry-owned Depository Trust & Clearing Corporation, the firms which are unconflicted should prosper under the new regime. They are those which provide either research only or execution services only.

He said on a visit to Australia last week that the area of commissions and unbundling research from execution had been looked at by regulators, including Australia, with various inquiries – such as UK’s Myners Report back in 2001 – recommending the abolition of ‘soft dollars’ in the least. These subsidised are services provided for ‘free’ to fund managers in the knowledge that the end client will cover the costs.

“MiFID II is much more strict,” Freeman said. They have to separate out the charges and demonstrate that the money spent benefits the performance of the fund… There are a number of providers who have decided already to fully unbundle the two [research and execution] and completely detach them,” he said.

“In the situation that the manager has to pay for research out of its own pocket, commissions on trading [typically paid for by the client fund] should go down but payments for research will need to go up.”

He said that the intention was to lift the quality of “sell-side” research. Only the biggest buy-side firms could afford to do all the research themselves.

“We process the trades and hold all the data and we can do that any which way,” he said. “We’d like to raise awareness about the change though. I think the practice of bundling services will eventually fade away. I think it will spread around the world.”

An interesting side issue is whether the UK, which will still be bound to EU rules such as this as of next January, will continue to abide by them after it exits. The answer is: probably, in this case.

Another interesting issue is how MiFID II will apply to fixed interest trades, where commissions are implied through being embedded in the price spread.

AMP Capital introduced some years ago the notion of paying sell-side researchers a form of bonus for good research, rather than paying their firms via trading activity but the initiative did not get picked up elsewhere. Similarly, the former Industry Fund Services, when it included what is now Frontier Advisors, introduced “directed brokerage”, whereby funds directed where their managers traded based on other metrics, mainly for discounts but also for research, but this system also floundered.

Things don’t happen quickly at the EU though. The second directive – the first was in 2004 – has already been delayed by 12 months and Freeman observed that the delay took about four months for the parties to agree.

Meanwhile, closer to home, China’s Stock Connect programs, which consist of Shanghai Hong Kong Stock Connect and Shenzen Hong Kong Stock Connect, have prompted a big increase in trade between the mainland and Hong Kong, especially since Beijing relaxed the limit on southbound investment last December.

Matthew Chan, Sydney-based executive director for APAC at DTCC, said that Stock Connect was one of a basket of initiatives which aimed to boost northbound – inward – investment and add more discipline and less volatility to the mainland markets.

“We’re working with firms outside China to help them take advantage of the initiatives, mainly with a northbound focus… We tend to get involved in discussions around the friction points.”

He said that “Bond Connect”, which is a similar initiative for the fixed income market, had also been raised as a possibility for the future. The Chinese authorities felt that there was insufficient foreign investment in RMB bonds.

The recently announced addition of variants of China bonds to Bloomberg regional indices (see separate report) would add impetus to the trend. Li Keqiang, China’s premier, who visited Australia last week, said in early March that the Government intended to introduce Bond Connect this year.