MiFID II Reaches Across the Pond: Is This the Calm Before the Storm?

Despite the view that MiFID II is a European regulation, US investment managers are experiencing disruption as they align their research payment and execution practices with the influential standard.

While MiFID II went into force on Jan. 3, 2018, US money managers of all types and sizes anticipate that MiFID II will influence their businesses, not just this year, but over the next year or two, according to a recent Tabb Group webinar.

Already larger firms have been unbundling research and execution fees, quantifying the value of research, and shifting equity trades from more expensive sales desks to algorithmic trading. And, many are focusing on transaction cost analysis (TCA), broker algo reviews and venue routing analysis to justify their broker selection and venue choices.

These trends emerged in the latest equity trading report by Tabb Group where 87% percent of buy-side firms surveyed expect to be impacted by the MiFID II regulation either directly or indirectly — a significant increase above the 76% who felt this way in 2017 and 68% in 2016.

“It’s become increasingly apparent that the rules are going to affect the US money management industry, even those that don’t have any European exposure,” said Dayle Scher, senior analyst at Tabb Group who discussed the 14th annual benchmark report " US Institutional Equity Trading 2018: Adapting to a New Reality,"  on a recent webinar.

This means not just global asset managers, but even mid-sized asset managers and smaller US-focused hedge funds say that MiFID II is looming over them and could indeed come to US capital markets.

“Certainly, medium and small investment managers are going to feel the most pain,” said Scher. “They don’t have the scale, they don’t have the budget to pay for research out of their bottom line, and they don’t have the internal analysts that the larger firms have.” Even so, investors have to show that they are aligned with the spirit of MiFID and that they’ve unbundled their research and execution fees, said the analyst.

But it’s not surprising that US money managers are conforming to MiFID II. “The dynamic here is that even if you are not directly impacted by European regulation because you don’t take European money and because you don’t manage European assets, you are competing with firms that are impacted by the regulation,” observed Alistair Cree, Product Manager, TCA, Analytics and Algo Wheel at FlexTrade.

“MiFID II’s emphasis on best execution, transparency, and trade reporting is actually fairly attractive to plan sponsors and potential clients of asset managers and hedge funds,” said Cree.  From a competitive stance, firms need to have a formal best execution process and an RFP [request for proposal] process. Even though they are not legally obligated to comply with MiFID II, there are competitive pressures driving the asset management industry, he said.

Most asset managers in the study are in the process of unbundling research from executions or have already done so.  “The pressure from consultants and investors is acute,” said Scher, noting that firms are receiving RFP questions as to their MiFID compliance or MiFID alignment even if they are not directly subject to the rules. In addition, many prominent asset management firms have said they plan to pay for research from their own P&L’s, which is the cause of the pain, noted Scher.

Reassessing Business Models

In fact, MiFID II has already caused the buy side to re-evaluate their business models, said Scher, pointing to how the regulation has irrevocably altered the research model and put downward pressure on their commission wallets.  Related to this, research budgets and commissions are being slashed to the bone, she noted.

For instance, the buy side cut over 31% of their research providers last year, while hedge funds cut 43%.

Firms anticipate cutting more this year, according to Tabb’s study. This, in turn, has had a devastating effect on commission wallets. Since, 2006, when commission wallets totaled $15.1 billion, they have declined by 43% to $8.6 billion in 2017, or about 5% compounded per year, said Scher.

Broker-Vote Solutions

Some plan to devote more money to technology such as broker-vote solutions to track the value of research. Sixty-one percent of firms surveyed plan to change their broker-vote process, even conducting it more frequently, such as quarterly. “This is what generates the intelligence to cut research provider lists,” said Scher, suggesting this could have a critical impact on how managers are valuing their research and how they’re valuing their brokers, said the analyst.

Justifying Fees

At the same time, MiFID II Is not the only anxiety-producing issue weighing on the buy side. Asset managers are worried about the future of their business models as the shift from active to passive ETF Index investments has put pressure on them to justify their fees. A total of $692 billion flowed into passive funds in 2017,  as reported by ThinkAdvisor based on Morningstar's annual fund flow report, which covers mutual funds and ETFs.

Almost two-thirds of the buy-side firms interviewed were focused on technology and automation, though it’s not clear this was all MiFID-related, said Scher.  Firms are devoting more money to technology for automating non-critical manual tasks and upgrading their EMSs/OMSs.  As a sign of the influence of MiFID II, one U.S. firm mentioned it was looking for an OMS that could split accounting between execution and research.  Others want to incorporate advanced data analytics and put more data science behind their process, said Scher.

Beyond Doom and Gloom

However, the impact of MiFID II is not all doom and gloom, and many see a silver lining to the rules, said Scher. Traders suggested there are advantages to aligning with MiFID II such as providing transparency to investors and shareholders.  From a best execution standpoint, traders like the concept of transparency into trading costs and execution-only.

Also, traders will have more autonomy to achieve best execution as their choice of a broker will be separate from how they pay for research. But asset managers will be under scrutiny to prove they attempted to obtain best execution for clients. While the first MiFID required firms to take all reasonable steps, MIFID II builds upon this further. It requires traders to take “all sufficient steps” to ensure best execution by considering multiple factors –price, cost, speed, likelihood of execution and likelihood of settlement.

More Algo Trading

Pressures from MiFID II to lower trading costs, coinciding with the active to passive shift, have further pushed the buy side into algorithmic trading.

In 2017, DMA and algorithmic trading’s market share jumped to 49% on a volume-weighted basis, from 45% in 2016, according to Tabb’s study. This is up from 41% in 2015 and 38% in 2014, respectively.

“By taking more trading in-house and automating through algos, firms are looking to reduce their overall costs without impacting execution quality and to source liquidity without impacting the stock price,” said Scher.

Sales desks, which provide high-touch trading, saw their market share drop slightly from 34% in 2016 to 33% in 2017. But, the  big drop occurred last year, when high-touch trading fell to 33% from 40% in 2015 and 43% in 2017, according to Tabb data.

“Desks are shrinking on the sell side,” said Sher noting that a lot of this consolidation is occurring as algorithmic trading increases.

While there isn’t necessarily a direct correlation between MiFID II and algorithmic trading, there is a connection between the unbundling of research and the desire to lower trading costs.

Another factor is that algorithmic trading is more amenable to quantitative analysis of performance than high-touch trading. “The reason is that you know exactly what you told the algo to do. Whereas by its nature, high-touch trading tends to come with more qualitative instructions,” said Cree.

Buy-side traders are also required to have a detailed knowledge of how the algos they utilize function.  With estimates of over 1,600 algorithms available worldwide, traders can spend a lot of time sifting through the noise. But, they may not fully understand which algos work best for specific order types.

Spinning the Algo Wheel

At the same time, buy-side firms must justify their choice of brokers and algos for certain parameters. Thus, they need evidence on why they selected a given algo strategy.  In line with MiFID II requirements, adoption of algo wheels is becoming popular among institutional clients, said Tabb’s analyst.

“MiFID II is a nudge towards thinking about trading more systematically and thinking about trading as a place that can be measured and monitored. That mindset is in tune with algo wheel,” said Cree.

The algo wheel is gaining attention on the buy side for various reasons. “It standardizes the process by which algos are selected, and it allows you to get unbiased data on the performance of the different algos,” explained Cree.

“The approach using algo wheels allows someone to run randomized experiments over their algo and broker selection choices,” he continued.  “That gives you unbiased data from which you can draw much stronger conclusions about the relative costs of the choices you made,” he said.

Despite some of the positive effects on helping firms to measure the quality of execution, very few buy-side firms expect to benefit from MiFID, said Scher. Only 27% of firms interviewed saw any benefits from MiFID II.

“It’s hard to convey the anxiety that traders are feeling relative to MiFID, relative to lower fees, and relative to the impact on unbundling to them,” said Scher. While the regulation hasn’t affected US managers that much yet, firms have compliance staff watching for the US impact.

“They are really sitting on tenterhooks waiting to see the impact.”