New regulations for equity research and Corporate Access – a threat or an opportunity?

Who does not remember the sweet 80s, when the world was a little bit smaller and a little bit simpler? A time when we shared music by copying our friend’s vinyl records to cassette tapes. A time when stocks were brokered by open outcry on the stock exchange floors.

Then it all changed. The world suddenly became computerized and made us more global. The age of digitalization had arrived, which ultimately meant that information began to flow more freely – buyers and sellers suddenly had access to more alternatives. Electronic equity trading was introduced and Spotify revolutionized our consumption of music.

A number of financial crises later, stock brokers and institutional portfolio managers find themselves in an increasingly complex world of continuous technology development, tighter regulation and constant price pressure, in need for new business models.

Over the last five years, banks’ commissions have declined by 25 per cent in the US and by 35 per cent in Europe, according to Greenwich Associates. Meanwhile, global equity research budgets have been cut by nearly 45 per cent, according to Frost Consulting. The number of equity sell-side analysts has been reduced by almost 50 per cent. In three years time, that number will be reduced by another 25 per cent.

Scary, isn’t it?

But it does not end here. On the 3rd of January 2017 – in one and a half years – the directive on markets in financial instruments (MiFID II) will be launched in its full capacity. An event that will make the world even more complicated for banks and portfolio managers.

Which in turn will affect listed companies.

A change in the MiFID II directive, currently lively debated around Europe, is basically about abandoning the traditional, slightly turbid model where managers indirectly pay for full brokerage services through dealing commissions.

Instead, the directive suggests introducing a new model in where equity research, buying and selling stocks as well as other related services such as meeting with analysts and companies (“Corporate Access”) are clearly separated and priced as the separate services they actually are.

By separating services, the directive aims at reducing cost, increase the availability and the quality of analysis and – not least – eliminating potential conflicts on interest. An example could be when a large American hedge or event fund – shorting a specific stock – is a good customer for the bank, but not always a good owner for the company in question.

The proposed changes will indeed have interesting implications for fund managers, banks as well as for listed companies.

Put in simple terms, the proposed changes will limit fund managers in their use of fund savers’ money, but also mean that they will have to bear the full cost of research and other related services such as Corporate Access.

Studies in the UK show that the performance of fund managers will be affected to such an extent that many may choose to cut costs for analysis and Corporate Access. This could have negative consequences, particularly on lower-ranked analysts and firms, but also when it comes to initiating coverage of smaller and medium-sized listed companies.

For banks and independent research houses, the changes will create a need to think through products and costs and in a more precise way segment and price research in an increasingly competitive world, which is not an entirely trivial question. What, really, constitute the value of research?

Being a top-ranked equity analyst who delivers unique insight will have a real and significant value in the future. To be one of many “me to” equity analysts who follow the stock may not have it. To be the first customer who receives the fresh research is more valuable that being the tenth on the list.

In addition, most banks cannot afford to cover everything for everyone. As opposed to today, where a senior analyst is able to cover 10-12 companies, he or she will probably be able to cover half that number in the future. To charge high fees for qualitative analysis will require deeper insight and even more customization.

For listed companies, limited analyst coverage is already a reality

On a normal day on NASDAQ OMX in Stockholm, seven per cent of the companies stand for over 80 per cent of the market turnover. The remaining companies have such small trading volumes, that it is simply not profitable for banks to cover them. Today, it requires a market capitalization of around SEK three billion for a Nordic bank to initiate coverage on any given company on the stock exchange. The decline in coverage is not just a Swedish phenomenon. Globally, the number of analysts per company has been halved from four to two during the last ten years, according to Frost Consulting. In addition, they have become more generalists. Today, between 35-40 per cent of all listed companies in the world lack any sort of analyst coverage.

The proposed changes in MiFID II might further increase the polarization between companies with analyst coverage and those without, as banks are forced to continue to prioritize analysis in order to profile their analysts and customize their products.

For listed companies, Corporate Access is an important part of banks’ brokerage service, alongside analyst coverage.

By tradition, banks have been able to offer Corporate Access free of charge, as the costs have been covered by dealing commissions. Through the introduction of MiFID II, such arrangements are no longer possible. For major companies with large institutional interest and/or ancillary business, Corporate Access will always be a service that banks will be willing to offer. For others, maybe not.

The question is, who will offer it then?

Banks will probably have to look for opportunities to outsource Corporate Access for non-priority customers, introduce new independent technology platforms such as Instinet’s Meet the Street and Ingage, or simply transfer the work load to independent actors such as NASDAQ OMX, Remium, Redeye or Financial Hearings. Another alternative is to leave it to the companies themselves, more or less forcing them to expand their IR departments or hiring IR- or Corporate Access Advisors.

Swedish banks, managers and listed companies will inevitably be affected by the new regulations. The directive will be launched in less than one and a half year – there is a lot to do and the time is short.