MiFID II: Disruptive Regulatory Change For European Financial Markets, Winners And Losers To Emerge Over Time

New Year 2018 sweeps in profound changes to financial markets in Europe with the implementation of the second act of the EU’s Markets in Financial Instruments Directive, referred to as MiFID II, and its accompanying regulation, MiFIR. Initially proposed in 2011, the new rules will subject all businesses involved in the distribution and trading of financial instruments across Europe to a changed, and in many cases, more stringent regulatory framework governing, among other things, enhanced investor protections, market abuse, and trade reporting requirements.

MiFID II took effect on Jan. 3 and builds on the original MiFID that came into force in November 2007 and focused only on the equity markets. It will apply to the 31 countries of the European Economic Area (EEA)–the 28 member states of the EU plus Iceland, Liechtenstein, and Norway. MiFID II affects financial market participants involved in investment activities: banks, brokers, asset managers, and financial market infrastructure companies (FMIs)–that is, exchanges and other trading venue operators.

A Double Whammy For Investment Banks And Brokers

Aside from one-off technology costs and heightened one-off and ongoing compliance costs, MiFID II will test banks and brokers (the sell-side) in two key ways.

By disrupting the research and trade execution model
MiFID II represents a disruption to the established bundled research and trade execution model prevalent in Europe.
Banks and brokers need to work out how to focus and price their research for a buy-side audience that previously received it without a separate price tag. They also need to take care regarding what they regard as “research”–for example, firms that treat sales-desk trading notes as outside the rules may find themselves with compliance problems further down the track. We expect the buy-side will cut research budgets generally and, specifically, reduce the number of research providers they use. This is, in part, because asset managers will now have to pay directly for the research their funds use, instead of having the funds pay for it in higher commission rates. Furthermore, some buy-side firms are likely to increase their in-house research capabilities.

Although the U.S. had already effectively unbundled commissions, MiFiD II has different rules, which may complicate U.S. sell-side firms’ implementation. In fact, the implications of MiFiD II’s rules for the sell-side in the U.S. could have been much more severe, were it not for the recently granted regulatory relief. The U.S. Securities and Exchange Commission (SEC) issued three “no-action” letters to allow market participants to comply with the research requirements of MiFID II in a manner that is consistent with U.S. securities laws, including allowing broker-dealers to be paid cash directly for research without having to register as investment advisors.

Sell-side firms and specialist research houses will need to pitch their fee schedules carefully. Cut-price research might attract an audience, as might more-expensive, high-quality research, but there will be less money to go around. Trade volumes are likely to move to intermediaries that can deliver low-touch execution at the tightest spreads, and high-touch, block trading in the most efficient way. We expect this to attract a proliferation of brokers specializing in low-cost execution and electronic market makers.

Overall, we expect a greater specialism in sales and research: sell-side firms that are well-regarded for either their research or the efficiency of their execution capability should fare much better than those that are mediocre. This may well hit the smaller brokerage firms hardest.

By moving client trades from banks onto exchanges and other trading venues
On the face of it, large banks will likely be less able to internalize client securities trades, that is, to execute them across their own books without putting the trade into the market. For derivatives, MiFID II finally implements the Group of Twenty (G-20) commitment to mandate the trading of standardized derivatives on organized venues, rather than over the counter (OTC, that is bilaterally). So we expect that MiFID II could channel more trades to regulated stock exchanges, multilateral trading facilities (MTFs), and organized trading facilities (OTFs).

However, some of the larger banks will likely be able to buck this trend by registering as systematic internalizers (SIs) for some asset classes. Indeed, many of the big names–such as Barclays, Deutsche Bank, JP Morgan, and Morgan Stanley–have already done so, for various asset classes. This adds to their compliance costs but allows them to continue to deal on their own account when executing client orders, so supporting their trading revenues. Indeed, as we note below, even if the banks initially lose some trading volume to other venues, it remains possible that, eventually, SIs could become a lever that the banks use to win market share.

Combined with the other changes under MiFID II, we see the move to organized venues as a negative development for incumbent sell-side firms. For example, research firm Coalition Development estimates that the largest banks could lose up to 15% of their cash equity revenues. That said, the unbundling of commissions could lead to increased trading volume, as it did in the U.S., which provides an opportunity for execution specialists and electronic market makingfirms to gain revenue and market share.

Notably, we see the burden as falling unevenly across the industry. We think that the extra compliance costs and the disruption to the existing research and trading model could play out badly for smaller brokers in particular, unless they have demonstrable strengths in research or execution. Slimmer margins will logically force consolidation in the sector.
We therefore expect that the long-term partnership in primary cash equities, brokerage and research that French firms Natixis and ODDO BHF announced on Dec. 6 will be followed by others.

The larger sell-side firms form the bulk of our ratings in this area, and we anticipate they will prove resilient. They will certainly be affected–not only in terms of their trading revenues, but also in terms of corporate and investment banking revenues and even in securities services, where their buy-side clients may well seek to renegotiate fees.
However, these firms tend to be well-diversified across asset classes beyond equities, and will likely be better protected by their scale efficiencies and registration as SIs. We therefore see MiFID II as one additional pressure (among many) on their business models, rather than as a single rating driver in isolation.

We see mixed fortunes for the interdealer brokers, who sit between the sell-side (and increasingly the larger buy-side) firms for less liquid trades. Additional compliance costs are likely to weigh more heavily on smaller firms, suggesting further consolidation in the sector and higher industrywide barriers to entry. Larger firms should be better able to absorb these costs, register as organized trading venues (MTFs and OTFs), and thereby continue to attract trade flow.
The waivers granted for large block trades will likely protect the interdealer brokers’ business. They may also be able to expand their data and other ancillary services.

A Catalyst For Consolidation For Asset Managers

We expect that the disruption to the research and trade model described above will be the key effect of MiFID II for asset managers. From what we see, most firms will absorb research costs themselves. We expect them to cut their external research budgets, not least because:

• The budget will now need to allow for the payment of value added tax;
• Some will expand their own in-house research teams; and
• Managers will be less willing to pay up if they cannot fully pass the cost of research to their clients through higher fees.

This implies a marked cost pressure for the active equity managers in particular, as the heaviest users of research. It would also fall hardest on smaller scale players as they have a smaller revenue base across which to spread the cost of third-party and in-house research.

We don’t foresee a dramatic change in market dynamics in the near term. But MiFID II could well prove to be a catalyst for consolidation among active managers, already under pressure from the trend toward passive index investing and exchange traded funds. We have already seen evidence that active managers are adopting more imaginative fee structures to better capture underperformance as well as outperformance, for the benefit of investors, but it is too early to judge the effect of this on manager behavior, or the degree of adoption by the industry. Even if there is some consolidation, active equity management will remain a highly fragmented market compared with other financial services sectors.

Mixed To Mildly Positive Implications For FMIs

European stock exchanges and clearinghouses (CCPs) were scarred by the original MiFID. In the years following implementation, we saw a proliferation of lighter-regulated competing trading venues (MTFs), a price war on trading and clearing fees for cash equities, and a sharp reduction in the margins for established players, offset in part by new trading volumes from a new wave of high-frequency traders. The stock exchanges’ market shares never fully recovered, and cash equity clearing is now a business offering marginal profitability, even for scale players.

By contrast, MiFID II may prove to be mildly favorable overall for FMIs. The thrust of the directive and legislation is to promote market transparency through a shift in trading toward more structured marketplaces. For example, certain derivatives contracts–those that are both cleared through a CCP and deemed sufficiently liquid–must henceforth trade on a regulated market or trading venue. This should mean that more fixed income and commodities trades will be executed on organized venues, rather than bilaterally, and some equity trades will be pushed from dark pools toward “lit” venues. The venues that could benefit from this shift will include the existing stock and derivatives exchanges, but also MTFs and newly-authorized OTFs.

However, the extent to which exchanges and MTFs actually benefit from improved flows depends heavily on whether SIs–that is, the overhauled crossing networks operated by the major banks–attract significant share. ESMA’s proposal to force SIs to use the same tick sizes as the exchanges and MTFs may head off the threat to a degree, but the outcome remains uncertain. Indeed, some market commentators consider it plausible that SI operators will gain market share from the other trading venues in the year or so after January 2018. Stringent MiFID II trade transparency requirements may also mean that some fixed income trading moves to non-EEA venues rather than those in Europe.

Furthermore, even if the venues see an improvement in trade volumes, including in a more diverse range of asset classes, the trading layer for former-OTC derivatives and cash securities is not where the big money is these days for FMIs. In an environment of sustained low market volatility and activity, FMIs have found strong growth mainly in data, index, and clearing activity. Some FMIs are active in trade reporting and other back office services, so MiFID II could prove to be favorable to them if they can expand their role in these activities.

In what could prove to be a negative for some FMIs, MiFIR Articles 35 and 36 introduce provisions regarding the right to nondiscriminatory access to trading venues and CCPs. This could bring into question the vertically integrated model used by firms such as Deutsche Boerse AG and Intercontinental Exchange Inc. The pace and depth of any consequences remain deeply uncertain, however–not least because the U.K. championed this provision, which could now fail to gain momentum after Brexit. In addition, the transitional implementation schedule and related regulatory discretions are likely to mean that real competition from this interoperability might not emerge until well after 2020.
Even if these provisions do stimulate change, they could, for example, simply yield some margin compression, rather than undermining the market dominance of the established market leaders.

The implications of MiFID II go well beyond the borders of the EU. One consequence of Article 23 of MiFIR is that many third-country exchanges and other trading venues will need to obtain a determination of equivalence to allow EU firms to continue to use them. Like much of MiFID II, recognizing such venues has come very late in the day: the EC finally recognized several trading venues in Australia, Hong Kong, the U.S., and, temporarily, Switzerland, as eligible for compliance with the trading obligation in mid-December 2017.

Putting all this together, our base assumption is a slight revenue tailwind for European FMIs trading and ancillary fees, with no strong competition or marked pressure on tariffs to emerge from interoperability. This implies that there would be no direct implications for our ratings on the European FMI groups.

Retail Banks To Adjust Their Service Provision

A final important change arises from the MiFID II ban on investment firms from paying or being paid any fee or commission in connection with the provision of independent investment advice or portfolio management. For example, banks which distribute mutual funds to their retail clients often receive and retain a portion of the initial sales charge from the fund manager, or else receive an annual, asset-based fee. This prohibition would be a marked change for intermediaries in many EU countries, although some, such as the U.K. and Netherlands, have already prohibited the payment of commissions for investment advice in recent years.

The prevalence of the restricted advice, bancassurance model across most of Europe means that MiFID II’s impact will be more muted than it could have been. For these firms, commissions and nonmonetary benefits can continue to be paid and received, as long as they comply with the inducement rules. Overall, we expect these firms to rise to the challenge. For the others, the potential loss of this fee pool could add to some banks’ uphill struggle to improve profitability, one that is increasingly focused on generating more fee income to offset pressure on net interest income.
In turn, product providers can expect banks and other intermediaries to renegotiate their distribution agreements.

To comply with inducement rules, firms providing restricted (non-independent) advice must be able to demonstrate that these inducements are designed to enhance the quality of the relevant service to the client and that they disclose such payments to the client. This sets the bar higher than previously, and includes the requirement to offer a wide range of suitable financial instruments, and to provide ongoing investment advice at least annually. National legislators might specify additional examples of quality enhancements. For example, Germany might specify the maintenance of large branch networks in rural areas–this seems to be a tailormade solution for the German savings banks and cooperative banking sector. Nevertheless, given the progression of digitalization, rising competition from fintechs, and the reduction in branch networks, meeting these requirements could become more difficult over time.