How to guard against Mifid’s unplanned effects
EU rules should not cut off smaller companies from capital markets
It has been in effect for a much shorter time than its ill-tempered gestation, but the EU’s second Market in Financial Instruments Directive (or Mifid II) is already shaking up equity investing throughout Europe and beyond. It is a year since one of Mifid II’s most contentious rules came into effect — requiring stock brokers to charge investors separately for company research and securities trading. As an FT series has shown, the reaction in equity markets has been significant. Beyond the predictable bleating from those losing their previously privileged positions, there are legitimate worries about unintended effects on market functioning — but nothing that undermines the validity of the Mifid II approach.
The ban on “bundling” research with brokerage aimed to remove conflicts of interest that might harm investors. One was investment banks and brokerage houses’ obvious interest in encouraging trading, which could bias their research. Another was that asset managers might not choose brokers in their clients’ best interest — the cheapest ones — when brokerage costs were both obscured by bundling and wrapped up with hard-to-price but useful services such as access to top executives.
Requiring asset managers to pay separately for research, thereby forcing brokers to name its cost explicitly, has led to a clear drop in spending. That has affected brokerages’ bottom lines, leading many to reduce the quantity and quality of research they do. That may seem like a bad thing; some surly voices will charge that the EU messed up. But this slashing of research spending is in many ways a feature, not a bug.
First, the conflicts of interest meant that the money spent on research was in part a vehicle for fattening the pockets of financial intermediaries to the detriment of end investors. Mifid II is one among many reasons for the welcome downward trend in the rip-off costs savers have long had to bear for having their money invested.
Second, if price transparency lowers demand, the most obvious explanation is that the research produced before was not worth the price. Still, much as the press was upended by the end of cross-subsidies from print advertising, there is a systemic cost from brokers’ retrenching from company research. Smaller companies are the ones research providers have dropped from their coverage. If less broker attention turns out to mean less investor attention, losing research coverage could make such companies’ stocks less liquid — making them still less attractive for investors, in a vicious cycle.
One remedy for this — research paid for by the companies themselves — is worse than the disease, in terms of conflicts of interest. Better for asset managers to undertake their own research, or non-brokerage companies to find a profitable niche in providing it.
If that does not happen, and Mifid II unintentionally makes capital markets less accessible to smaller companies, that reflects a failure in the market for company information. The cost of researching a company is probably the same regardless of its size — hence why smaller companies are undercovered. When markets underprovide a public good, such as valuable information, there is a case for public intervention.
There are various appropriate solutions if the problem turns serious: subsidies or tax credits for small company research; public-private collaboration; and EU-wide standardisation and reporting requirements, making research cheaper. All should be pursued within the EU’s capital markets union agenda. That agenda will itself deepen the liquidity pool for smaller EU companies — which could turn a vicious cycle into a virtuous one.