Smaller companies fear threat from new financial regulation

City broking houses have warned that new European financial regulations risk damaging small British businesses by throttling coverage of them in research provided to investors.

Brokers publish research on a range of companies for fund managers and other institutional investors, which gets bundled into the cost of their overall services to clients alongside the execution of trades. These fees get passed to investors.

This will change under Mifid II, Europe’s second Markets in Financial Instruments Directive that will go into force in January 2018. Asset managers will have to be clear that they are using investors’ money to pay for so-called “sellside” research, or cover the costs themselves. Under Mifid II, free research that asset managers receive from brokers would be considered an “inducement to trade”.

The new regulation is expected by some brokers to curb the amount of research provided by making them charge separately. The worry is that the many small and medium-sized listed companies that rely on these notes to promote their stocks could be cut off.

Larger companies, which are often of more interest to a wider pool of investors, are likely to suck up budgets for research, according to some executives, as firms become more selective about the companies and sectors they want to cover.

Steven Fine, chief executive of Peel Hunt, a UK broker, said that Mifid II seemed to have “a broad-brush approach to all research providers, which we feel has some unintended consequences at the smaller end of the market”.

“The concept is that Vodafone is no different from Topps Tiles [a small-cap UK company],” said Mr Fine. “The payment for research in all of those companies is now standardised in the same way. It feels like there is an unfair advantage to larger-cap companies, which have a greater number of analysts writing on them.”

Mifid II “has more significance than Brexit and Trump”, argued Darren Ellis, chief operating officer at London-based Zeus Capital, a boutique brokerage. “It changes the way the City works.”

Mr Ellis said brokers would be left in a difficult position: “I think the power will probably move even more so to the buyside, as they can decide what research they’re going to take.”

As much as two-thirds of the $30bn of commissions generated worldwide constitute research fees, according to Frost Consulting, an advisory firm specialising in regulatory compliance.

Although some fund managers, including Neil Woodford, have publicly stated they will absorb research costs, it is likely that many will seek to continue charging them to clients.

Executives at several broking houses, speaking on condition of anonymity, said that asset managers were proposing significantly smaller budgets for research. A study by Quinlan & Associates, a strategy consultancy, predicted a “decline in global research spend of up to 25-30 per cent by 2020”.

Reduced research payments could see brokers restrict their coverage of smaller businesses, according to brokers. Jon Gerty, head of regulation and compliance at Shore Capital, an investment group, agreed that Mifid II’s requirements were “likely to result in a decrease of available quality research, especially on small-medium enterprises, who rely on brokers to promote their shares”.

Mr Gerty said this, alongside other changes to market structure contained in Mifid II, could lead to liquidity in alternative markets drying up.

“There is a question whether regulators have undertaken a full and effective cost-benefit analysis of the potential unintended consequences of Mifid II, and the unbundling proposals in particular, on SMEs and their growth,” Mr Gerty said.

Although Mifid II is a European regulation, its impact will be global. A recent survey of more than 100 North American investment funds, conducted by financial technology firm Investment Technology Group, found that 82 per cent planned to fully unbundle research and execution payments to all their brokers.

The threat of the new rules has been known for some time, but it is only now that many groups are starting to make preparations.

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