September 26, 2017

Since the 2008 financial crisis, equity markets around the globe have recovered impressively and are hitting new records. What has not recovered in the past decade however, was the trust of the private investor in his banker and investment advisor.

An important purpose of the vast set of new rules known as MiFID II is to restore this trust, root out conflict of interest and strengthen the protection for the non-professional investors. In a nutshell, the investment service industry must act honestly, fairly and professional according to the new set of rules.

An important topic we will discuss here as a part of the theme Investor Protection is the ban on inducements. More specifically, the “unbundling” of investment research and the order execution.

Consider the following example: you are building your new “dream” house and you become aware that the summer holiday of your architect was partly paid for by your contractor. Quite likely, a difficult discussion with your architect will follow and whether his services will be prolonged is doubtful.

In the Netherlands a complete ban on inducements for the banks, portfolio managers and investment advisors servicing the private investor was introduced in 2014. With MiFID II this inducement ban was extended to investment banks and portfolio managers servicing professional investors such as pension funds. “They must not accept and retain fees, commissions and any monetary or non-monetary benefits paid or provided by any third party.” Only for certain specific services and under special conditions inducements are allowed for brokers and investment banks servicing the institutional investor.

The new market rules consider the traditional free research provided by brokers and banks as inducement, which means that starting in 2018 their clients, the money managers must pay for the company research they receive.

It is currently unclear what the definition is of “research”. Is using publicly available research considered an inducement? If so, when is research considered publicly available? Is research provided by Bloomberg public information? These are interesting topics which we will be addressing in our next i-KYC Trend Letter.

The EU legislator considers good execution of a trade as a different service to providing a company research report. So far, the cost of the investment banks for the team of analysts and the research they produced was funded by the commission income from the execution of the trades. The rationale is that with the unbundling of the cost covering research and the trade execution, transparency for the client will improve.

The business models of investment research industry will be significantly affected by these reforms. In future, asset managers will fund the external research from their own P&L. Whilst this may prevent conflict of interest, it is likely that they will be choosier about the expensive research they buy. This is good news for the independent research firms, but what about the private investor? MiFID II also requires investment firms to demonstrate that they get the best price for their clients when they execute a trade. The obligation to pay separately for your research could lead to more transparency and competition, which could drive down the commission fee and trading spreads. Good news for investors that the trading costs will be reduced with 0,2% but personally I would prefer to pay 0,4% more to receive quality research that will improve the performance of my portfolio. Something to think about.

September 2017

Pieter Hoogeveen