Wealth managers aren't yet in the position to give three cheers to the sweeping regulatory changes that took effect in the EU a year ago - also affecting those outside Europe who interact with the EU.

A year since MiFID II reforms to European investment and financial markets took effect, the wealth management industry appears to give a qualified welcome to how the rules apply so far. It argues that rules have pushed up costs, but also made them more transparent.

The second iteration of the Markets in Financial Instruments Directive requires wealth managers to give more data on their costs and charges, and forces firms to charge separately for analyst research. The rules, which took effect at the start of 2018, were designed to reduce mis-selling and protect investors from unsuitable products and services. Critics have claimed that MiFID II is excessive and that its cost increase outweighs any benefits. According to Boston Consulting Group, it has cost firms about $2.1 billion to get ready for the directive.

When the directive took effect, it kicked in about five months before a new General Data Protection Directive came into law – hitting the EU financial sector (and other sectors) with another heavy compliance burden. 

So what do practitioners think of how well MiFID II is working so far?

“When it comes to the ex-post costs and charges disclosure required by MiFID II, issues with the quality and patchiness of data provided by fund manufacturers are causing concern among wealth managers and other fund distributors,” Andrew Watson, head of regulatory change at JHC, said. 

“For many years, wealth managers have been completely transparent about the fees they apply. However, the need to provide a personalised disclosure to the end investor, including the costs and charges applied within investment products, will inevitably result in interesting questions from retail customers,” Watson said.

Fabrizio Zumbo, associate director, retail, at Cerulli Associates, the analytics and research firm, gave a reminder of what MiFID II means. 

“MiFID II introduces new rules on product governance, the appropriateness test, inducements and disclosures to investors. According to the new regulatory framework, [the] product manufacturer must ensure that products are sold in accordance with the needs of the clients. They must also provide specific information to distributors about the same products. Furthermore, independent advisors and asset managers are banned from receiving third-party commissions. MiFID II also requires a more detailed disclosure of costs and charges and forces firms to disclose whether they provide investment advice on an independent basis. On the investors’ side, this means more transparency on costs and a more client-centric investment advice stance that is not based on commission-driven dynamics, which ultimately favour just manufacturers and distributors instead of end clients,” he said.  

Distributors will have higher costs as a result of the directive’s product governance rules, prompting organisations to cut the number of funds they put out.

“IFAs could reduce the number of funds to offer to their clients due to increased costs per provider, while fund platforms may become more selective with the products to include in their offering. This could mean less options for end investors but more detailed information on the products on the shelves,” Zumbo continued. 

“As MiFID II will increase the transparency of costs and charges, and require appropriateness tests for a wider range of products, asset managers will need to make strategic decisions about their current and future offering. This is triggering a move towards lower-cost, less complex and passive funds, which are currently gaining momentum among retail investors in Europe,” he said.

Under MiFID II distributors can only be paid retrocessions if they provide execution-only services. In the case of exchange traded funds – an increasingly popular way of tapping into markets - they do not pay commissions to distributors so should benefit from the new rules, Zumbo said. Evidence is already emerging that this is happening. “While ETF assets stood at €365 billion ($416 billion) in 2014, at the end of August 2018, ETF assets amounted to €677 billion (with €37 billion of net inflows from January 2018),” he said.
 

Unbundling
One effect of MiFID ll is getting firms to disclose their research costs, encouraging sell-side businesses to cut back on coverage, a situation that has worried some industry figures concerned about a gap in information. 

“Expenditure on small-cap research has decreased significantly, and coverage per company at the smaller end of the market has declined accordingly. The squeezed research houses are putting their efforts into the larger liquid stocks, rather than the lower-ticket small caps which are typically more difficult, and now more expensive, to analyse. This creates two problems: much lower liquidity at the smaller end of the market – which we are seeing already – and more capital into large-cap stocks. This, combined with the broader shift to passive investments and continued inflows into ETFs and index tracker funds, is artificially increasing prices and causing investors to herd into large-caps,” Michael Horan, head of trading at BNY Mellon’s Pershing said. 

“Lower liquidity in small and mid-caps has a number of potential implications. During periods of market volatility – such as the correction seen in ‘Red October’ in 2018 – it makes it more difficult for traders and investors to unwind positions in what was previously a more liquid market, causing wider spreads and greater price swings. Over the longer term, a focus on large-cap indices from both research houses and investors means we could see a hit to smaller company IPOs due to a lack of investment appetite, meaning fundraising will need to come from other sources,” he said. 

“Exchanges in particular are monetising market data the most, which has huge consequences on the ability for smaller asset and wealth managers to trade on a level playing field. This is because the cost of pre- and post-trade exchange data – either from data providers or exchanges themselves – is on an upwards trajectory, having increased across Europe by around 15 per cent in 2017 alone,” he continued. 

Chris Turnbull, co-founder, Electronic Research Interchange, said that some behaviours haven’t changed since MiFID II came into force 12 months’ ago. 

“It is easy to see this as a disappointment and ultimately a signal of MiFID II’s struggles, but things are starting to move in the right direction. In hindsight, it may have been naïve to expect quick-fire change from an industry that has operated in a certain way for decades. A mitigating factor has been that the FCA [Financial Conduct Authority] has not been active enough in enforcing penalties and facilitating the transition,” Turnbull said.  

“Firms have been given free rein, so it is unsurprising that some haven’t acted in the spirit of the regulation. The overwhelming majority of firms were unprepared for the changes last January, and the state of confusion continued throughout the year. We must now accept that achieving an effective research market will be a slow process, as we are very much in the infancy stage at this point. It could take five years for the regulation and implications of MiFID II to finally bed down across the industry, so we have a long way to go,” he said.

Jason Merritt, who is director of business development at NICE Actimize, an enterprise software business, said it was so far hard to know if the directive has cut incidents of abusive market behaviour. 

“There are currently no figures available for STORS (Suspicious Transaction and Order Reports) in 2018, so it’s difficult to gauge the impact of MiFID II on Market Abuse, and there has been very little in the way of enforcement actions this year.  We have not yet seen a greater number of regulatory investigations  so far,  and it may still be too early to see impact of the new regulation. The implementation of the LEI (Legal Entity Identifier), a 20-digit alphanumeric code that enables a unique identification of legal entities across the EU, will enable regulators of the data to monitor for market abuse across firms and across products. Historically the same client was identified differently across firms, now there will be no hiding place for clients who attempt to disguise their illegal activity by splitting orders/executions across firms," he said.

There are more challenges ahead, Alex Dorfmann, Senior Product Manager at SIX, said.

“One year on from the advent of MiFID II, firms are gradually getting to grips with the challenging processes involved. But with the next potential stumbling block of ex-post costs and charges reporting requirements and the implementation of the European Feedback Template (EFT) coming into play for the first time this January, there’s scarcely time for firms to draw breath. Perhaps due to the sheer volume of regulatory changes, a quick-fix approach still prevails in the industry," Dorfmann said.