With the ‘Markets in Financial Instruments Directive II’ (MiFID II) having hit the European market, with effect from January 2018, the financial services industry, especially investment research is undergoing some paradigm shifts. Of the many ramifications which MiFID II is expected to bring in its wake, the de-coupling of investment research from trading (rather unbundling of revenues) is, perhaps, one of the most-widely discussed. Research from now on will be especially accounted for – clients will know what and how much they are paying for. Transparency is the key word here. The endgame will be beneficial for all parties concerned but just like any other reform process, there is some transient pain involved.
But before we go there, let us quickly review once what the situation has been so far. Even without having to worry about navigating the labyrinths of the MiFID II maze, the financial services industry already has enough problems on its plate. On the Buy-side, the traditional long-only equity-focused active managers, who also incidentally happen to be the major consumers of sell-side research, have been grappling with low returns, with more than 80% of US active managers underperforming their market benchmarks in 2016.1 Plenty of studies have shown that the alpha generated by active fund management does not outweigh the investment style’s incremental costs. The ever-increasing popularity of passive investing, coupled with low returns of active-management has resulted in significant downward pressure on management fees charged by active managers. It is but natural that the research which fuels the active fund management will come under strict scrutiny.
The situation is not too better on the Sell-side either. Top lines have been witnessing constant pressure in the aftermath of the 2008 crisis. Since 2009, global revenues have declined 20% for equity and sales trading and 10-15% for investment banking. 1 A McKinsey survey of the buy-side has estimated that payments attributable to sell-side research have already fallen by up to 30%.1
MiFID II to result in further cost-rationalization and consolidation in investment research:
With MiFID II setting in, profitability of active asset managers, which already was under pressure, will take a further hit. Previously, the trading expense of asset managers was passed on entirely to the managers’ end-clients. But with MiFID II clearly demarcating research costs from trading costs, there are high chances that end-clients of active asset managers will refuse to absorb research costs. McKinsey studies estimate a profit erosion of 15-20% for European asset managers because of this1. Asset managers, who will be on a tight external research budget, will likely increase their reliance on internal research teams in order to control costs.
The Sell-side, however, is expected to take the worst hit. Selective demand (read reduced demand) from Buy-side clients will result in a direct hit to the top line. Additionally, the delineation of research costs as separate from brokerage fees will mean that the Research departments of brokerage houses, which till now were cost centers, will become revenue centers, hence, making them accountable for their standalone operations. Instead of pushing research (irrespective of quality) as part of a bundled package, the research departments will now have to prove their mettle – the end client should clearly be able to see value in the research produced by the sell-side. This “survival of fittest scenario”, while ultimately beneficial for the investment research industry, will nonetheless, cause short-term pain with elimination of non-actionable research, reorientation of sector/geography coverage, and further reduction of research headcount.
The resultant shakeout in the investment research industry will likely result in a few large global investment banks that would be relied for waterfront coverage, and an increasing number of regional ones and independent research providers who would be relied for geographic and sector-specific research respectively.
A guiding torch in this Maze - Process Transformation Partners
“While we expect big asset managers to be ‘largely compliant’ with MiFID II, the work is far from over. When we speak to our clients at buy-side and sell-side firms, we note that all of them have implemented incremental technology, added governance, and processes to comply with MiFID II, but the sword of Damocles continues to hang over them due to outstanding process uncertainties and the potential for possible misinterpretation or omissions.’ says Vikas Verma, Vice President & Global Head for Sutherland Research.
It is evident that some amount of pain is inevitable during this transition. Nonetheless, financial services firms can alleviate this pain by revisiting their research sourcing strategies. Those players whose research band-width has become constrained by size or cost considerations can expand it by leveraging the sector and geographic research expertise, and the cost efficiencies of large global process transformation firms, like Sutherland.
One major area where both buy-side and sell-side can increase efficiency is by adopting automation in a major way. Getting research on your fingertips at the click of the button is what research consumers demand from their research providers today. Firms which can provide this will be front-runners in the race to the top. For instance, financial modeling- which remains a time-intensive yet a crucial cornerstone of any investment research exercise can be done at a much faster pace by embracing automation tools. Buy-side and sell-side firms can partner with transformation partners like Sutherland who excel in this field. Not only does Sutherland have a deep domain expertise in various sectors and geographies which buy-side and sell-side firms can leverage, it has also developed automation tools like ModelBot which has significantly accelerated its financial modeling process by using this proprietary software solution. ModelBot builds on real-time access to a wide range of cross-sectional and time-series financial statement data, obviating the need to expend significant time in manually building and updating financial models.
Research differentiation and cost-optimization are the key elements in order to survive and thrive in a post-MiFID II era. By leveraging the research and analytics capabilities of process transformation providers, investment firms and sell-side can continue to engage in high-quality differentiated research while realizing significant cost-efficiencies.References
1. McKinsey: Reinventing Equity Research as a Profit-Making Business (June 2017) (http://bit.ly/2z8DX2U)