If you bothered to read the news over last Christmas you may have heard about something called Mifid II. The European legislation, the second iteration of the Markets in Financial Instruments Directive, came into force on January 3.
Among the many requirements set out by the directive are rules regarding sellside research, designed to increase transparency in the costs charged by brokers to investors. In short, brokers can no longer offer analyst reports in exchange for fees generated from trading. Instead, research would have to be paid for separately by clients who wanted more information on a stock or security. In media parlance, it was an “unbundling”.
The legislation inspired several pieces on the death of the sellside analyst — some even from this institution.
While many welcomed the increased transparency which the directive bought, there was some concern that it would have a negative effect on market liquidity. The logic went like this: companies which brought in lower trading commissions, by virtue of size or volume traded, would be dropped from analyst coverage by brokers, leading to illiquidity and potential mispricings in equities and other securities.
However so far this year, this does not seem to be the case.
A piece of research by Jeremy Monk of AKRO, published on the CFA Institute's blog, takes a look at the number of forecasts across indices for three company metrics — sales, net income and earnings-per-share — in the first half of this year versus the previous decade. The methodology is laid out in detail in the blogpost.
For instance, here is the data for the S&P 500:
Unsurprisingly there's no great change year-on-year, given the majority of analysts covering US companies do not fall under Mifid II rules. Well, for the moment anyway.
Yet, for European small-caps — personified by the STOXX Europe Small 200 index — the data are pretty unexpected:
So in the first half of the year, the amount of forecasts for this selection of European small-caps grew, with earnings-per-share forecasts returning to just below 2013 levels. Monk is so surprised he labelled it as a “blip” on the chart. The trend repeats itself across the larger market capitalisation STOXX Europe 600 index:
Monk suggests this is down to productivity. Analysts, terrified by the prospect of losing their cushy jobs churning out earnings forecasts, have upped their game in a bid to prove their worth to the firm. This makes sense intuitively.
There are some other possibilities. One is that a lot of the restructuring of the sellside in anticipation of the directive came into law. After all, brokers had known about the rule change for years. This may explain the modest decline in forecasts between 2016 and 2017 across both European indices.
Another reason may be that while European banks are not out of the woods yet by any means, a lot of the pain suffered in 2016 from historically low interest rates has been mitigated. For instance, Commerzbank recently confirmed plans to start paying a dividend again after shedding 9,600 jobs as part of a restructuring plan. So improved levels of forecasts may just be the beginning of a return to pre-crisis norms.
Of course, the number of forecasts is not the only way to measure whether Mifid II has affected the markets — trading volumes, as suggested earlier, are perhaps another way to gauge the Directive's effects.
However, according to research from Union Investment published four weeks after Mifid II came into force, there was “no material impact on liquidity”, with volumes “good and robust” versus 2017. Similar conclusions were reached by senior fixed income and FX traders at the AFME European Trading & Market Liquidity conference in April, according to EuroMoney.
Yet the lack of noticeable change in volumes and forecasts doesn't tell the whole story of the buy and sellside adapting to a brave new world.
On the buy side — hedge funds and the like — the cost of buying research has led to cost reductions elsewhere in their businesses. As recently cited by the FT, budgets have been squeezed 20 per cent to accommodate research spending, according to Greenwich Associates.
On the sellside, the legislation has had a more drastic effect. A veteran of the sellside told us that street estimates for a drop in revenues of 30 to 40 per cent from Mifid II have proven fairly accurate.
They also revealed first quarter business activity “hit a wall” as the buyside and sellside tiptoed around each other, trying to figure out what constituted chargeable research, and what didn't. Since then, they said, activity has returned to normal but they anticipate a difficult fourth quarter as clients review the first year of spending under the new paradigm.
Boutique research firms, who do not generate cash from trading, have also suffered as their affordable price points have come under pressure from mammoth investment banks looking to maintain both market and mind share, according to a recent FT article.
So on the surface, all seems serene. Volumes and research output have so far proved stable. But below the waterline, in the world of market participants, there's a feeling that there's still a lot more pain to come as the great reconfiguration continues.
Related Links:
The unmourned death of the sellside analyst — FT
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