Mifid ii, Unfair Market Structure Makes Investors Worry About Their Future

As sweeping regulations are about to take hold in Europe, impacting both buy and sell side financial firms in the US, many of the smaller players are unprepared for the changes, according to a TABB Group report. MiFID II regulations and the unbundling of research and commissions will alter the buy and sell side landscape. This comes as the report reveals that close to half of all buy-side market participants call the equity market structure unfair and ineffective.

MiFID II unbundling of research likely to have sweeping impact across the globe

Sweeping MiFID II regulatory changes coming out of Europe effective January 3, 2018, will impact 76% of all buy-side firms – even those outside the EU – according to TABB Group report titled “Institutional Investors Facing Difficult Challenge as Passive Investing, Unbundling, and Cost Pressures Threaten Their Very Existence According To TABB Group’s Latest Research – US Institutional Equity Trading 2017: In the Eye of the Storm.” The report follows previous work by TABB noting the changes in institutional research consumption.

MiFID II requires that brokerage firms “unbundle” their research costs from commissions. Large brokerage firms have charged a much higher commission to compensate for their research, which at times has been criticized for its lack of independence.

What could happen as a result of MiFID II is the top research is a beneficiary, while mediocre or bias research finds difficulty gaining traction in a free market environment.

While MiFID II is a European regulation, any buy side firm conducting business in the region will be impacted. “Many of the large buy-side firms plan to follow and implement MiFID II regulations across the globe,” said TABB Group’s Valerie Bogard, who co-authored the report with Larry Tabb and Dayle Scher.

The TABB Group study found that, in particular, smaller buy-side firms are unprepared, with 74% reporting they are waiting for an industry consensus to emerge before making decisions. Only 9% of large buy side firms and 15% of medium-sized firms are waiting to take action. Most of the smaller firms had no plans on how to manage the changes that were taking place in the industry, including the move to passive investment types.

Bogard thinks smaller firms are being squeezed by the industry trend towards fee compression, as investors increasingly shift towards passive investment vehicles. They don’t have the money to invest in new technology and handle increased regulatory burden. “Costs are first and foremost a concern to the smaller fund manager,” she said, although noting that they typically could adapt to change quicker than the larger firms.

There is a significant differential in the value placed on brokerage firm research. Large firms tend not to value the research much, the study found, while medium firms were slightly negative on brokerage research. Smaller firms, many without the budget for their own research operation, tended to find the brokerage firm research most valuable.

45% of institutional players say equity market structure unfair

There is a general dissatisfaction with market structure among the buy side firms surveyed in the TABB Group study.

Fully 77% of medium-sized firms think the current equity market structure is “unfair,” compared with 45% of all buy side firms that think the market structure is unfair. Of the largest buy-side players, however, only 25% think the market is unfair while 38% of all respondents think the equity market structure is ineffective.

The most investors, 39%, point to fragmentation of stock trading platforms as the problem. With nearly 40 exchanges and dark pools, the buy side finds understanding the idiosyncratic order and routing rules challenging when placing stock orders. “But they don’t want regulators to solve the problem due to fears about unintended consequences,” Bogard told ValueWalk. “They are looking for market-based solutions.”

High frequency trading was viewed as a problem by 23% of respondents, while transparency was viewed as an issue by 19%.

That wasn’t the only area of dissatisfaction. Many of the smaller firms, while consolidating their brokerage relationships, are unsatisfied with their brokerage firms.

The TABB Group study showed that 47% of buy-side firms, mostly those with smaller assets under management, “did not think their brokers were doing anything innovative.” Buy-side firms who thought innovation was taking place primarily named customized algorithmic trading offerings as the most innovative broker efforts.

Buy-side firms value innovative algos that can be quickly and intricately customized around the firm’s specific strategies — making recommendations on how, when and where to trade an order based on a firm’s preferences. Building these algos requires a strong, robust technology infrastructure as well as in-depth knowledge of a constantly changing market structure.

“Eventually, machines will dominate decisions but humans will still need to apply their intuition and discipline in order to gain the upper hand,” noted Erez Katz, Co-Founder & CEO of Lucena Quantitative Analytics, a firm that develops algorithms for hedge funds and institutional investors.  “The human factor is here to stay for quite some time.”

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