European regulators have long held opposing views on unbundling, the process of separating the costs of research and trading. The UK’s Financial Conduct Authority (FCA) successfully pushed for strict unbundling rules to appear in Mifid II, against the wishes of French financial regulator the Autorité des marchés financiers (AMF). Now, with the UK set to leave the EU, could some of those rules be pared back?
There’s ‘definitely talk about Mifid III’ and it could be used to ‘unwind some of the more draconian unbundling capabilities, or at least make modifications to them,’ says Sandy Bragg, principal at Integrity Research Associates, an advisory firm focused on the global investment research industry. ‘I think there are definitely concerns within the UK industry that Mifid III will end up deregulating relative to where the UK is.’
The rules around unbundling may be ‘modified in some way,’ says Patterson. But she is betting against wholesale changes to the current system. ‘It’s not immediately clear that, when the UK leaves, those rules are suddenly going to disappear. A number of regulators like the general concept of more transparency and more governance over the process.’
Under Mifid II, which came into effect at the start of 2018, investors must pay for research out of their own pockets or via separate accounts agreed with their client. The new regime has led buy-side firms to re-evaluate their use of external research and, often, cut back. With less money flowing to research providers, there are fears that small and mid-cap companies could see a drop in coverage – an issue highlighted by the AMF last November when it called for reforms.
Robert Ophèle, chairman of the AMF, said in an interview with the Financial Times that some aspects of Mifid II would need to be reviewed in light of Brexit. ‘Even without Brexit we would have had to look at it again because there are very detrimental effects on research, especially for mid-caps, that’s absolutely clear,’ he commented.
Around the same time, Cliff, the French investor relations association, released a study that found coverage of French firms with a market capitalization between €150 mn and €1 bn ($170 mn and $1.31 bn) fell from five analysts to three over the previous three years.
The FCA has also watched for changes to coverage of smaller companies. Its preliminary conclusions differ markedly from those of the AMF, however. ‘I think the evidence is, so far, inconclusive and does not suggest the dramatically negative impact that some predicted,’ said Andrew Bailey, the regulator’s chairman, in a February speech to the European Independent Research Providers Association.
Data shows that analyst coverage on the LSE’s Main Market and Aim remained ‘broadly consistent’ between 2015 and 2018, he added.
Hard, soft or no Mifid?
Disagreements between the FCA and AMF over unbundling date back to at least 2014, says Bragg. ‘It’s a long-standing debate between the two and it really caught our attention because rarely do you see regulators publicly disagreeing,’ he observes.
Many Brexiteers – those strongly in favor of Brexit – view the UK leaving the EU as a chance to deregulate the economy, so they may be surprised to find that it is actually regulators in mainland Europe that plan to cut red tape. ‘It is quite an irony, given that the hard-core Brexiteers are chomping about throwing off the yoke of European regulation,’ says Bragg. The FCA and AMF, plus the European Securities and Markets Authority, are all conducting reviews into Mifid II’s unbundling rules, so plenty more evidence should emerge about the impact on small and mid-cap coverage.
The changes add further pressure to an industry already in decline. The total number of research analysts working at investment banks fell by 10 percent between 2012 and 2017, according to figures from Coalition, a data provider.
‘Small companies have been suffering from limited research for some time, but still manage to get covered either through a brokerage contract or as an add-on to a bigger sector,’ says Marina Zakharova de Calero, director of IR at communications consultancy Powerscourt and head of IR at McCarthy & Stone. ‘With the commercial reality of unbundling being so brutal, the stock or story has to be unique to still justify the time spent on research.’
Any plans by national regulators to pare back unbundling will be complicated by the global spread of Mifid II’s research-payment rules. A number of asset managers, including AllianceBernstein, MFS, Baillie Gifford and Capital, have decided to adopt the European approach across their operations worldwide.
That has created an issue in the US, where banks and brokers are barred from receiving cash payments for research unless they register as investment advisers, which then increases their compliance obligations.
This situation prompted the SEC to issue a 30-month no-action letter, allowing US companies to comply with Mifid II regulations.Could the US market decide to adopt unbundling rules more broadly? Bragg doesn’t see that happening, at least not for the time being.
‘There doesn’t appear to be any broad groundswell [among US investors] to adopt the hard-core Mifid II approach of absorbing research costs,’ he points out. ‘It further isolates the UK in that US regulators clearly aren’t buying into the UK perspective on unbundling and there is push back from the continent.’
Data protection post-Brexit
Brexit also has implications for another major piece of European legislation: the General Data Protection Regulation (GDPR). As things currently stand, under a no-deal scenario, data transfers from the EU to the UK would not automatically comply with European data protection rules.
GDPR, which came into effect in May 2018, made sweeping changes to the rules around data collection and storage. Companies deemed non-compliant face fines of up to 4 percent of global annual revenue or £20 mn ($22.6 mn), whichever is higher. During the first eight months of GDPR, authorities received close to 100,000 complaints about breaches, according to figures released by the European Data Protection Board. Early victims of the new regime include Google, which was fined £50 mn in January for issues related to its Android operating system.
The first step many UK companies have taken is to put in place legal clauses they can attach to data transfers in the event of a no-deal Brexit, says Jane Shvets, partner at law firm Debevoise & Plimpton. After that, companies should review the consent they have received from EU-based individuals on databases, including IR contact lists, she adds. It may be necessary to send out notices or ask for consent again, depending on the permissions that were originally granted. IR teams wondering why their firm’s data protection officer hasn’t yet implemented changes should be aware that many are waiting to see how Brexit plays out before they take any ‘heavy-lifting steps like the re-permissioning of databases,’ explains Shvets.
Data transfers from the UK to the EU, by contrast, will not require changes because the UK regulator has said it views the EU market as having ‘equivalent’ data protection. At some point, the UK should expect similar recognition from the EU, but it is not clear how quickly that would happen in the event of a no-deal Brexit.
This article originally appeared in the Summer 2019 issue of IR Magazine.
