European bond investors are stuck in a quandary: how much should they pay banks for credit research after insisting for years that it has no price?
With less than six months left before the start date of the European Union’s new MiFID II rules that require banks to separate charges for trades and research, answers are starting to emerge. Proposals include 120,000 euros ($138,000) a year for premium packages from Credit Agricole SA and Nomura Holdings Inc. covering a range of research.
Regulators insist that the cost of credit research is built into the bid-offer spread — the difference in price at which a broker is willing to buy or sell — so spreads will narrow when this charge is stripped out. The industry dismisses the claim, and some asset managers argue that charging cash will mean less research and higher costs for investors.
“If traders don’t adjust spreads for research, MiFID II becomes a new revenue source for investment banks and an additional cost for investors,” said Duncan Warwick-Champion, head of corporate research at ECM Asset Management, a fixed-income specialist of Wells Fargo Asset Management. “I’m not sure this is what the regulators intended, but to me it is the most likely outcome.”
The MiFID II market-rule overhaul attempts to unscramble the omelette of services involved in trading securities, including research, by requiring clearly marked fees for each. The intention is to address conflicts of interest such as the understanding that an investor will give a bank its transaction business in exchange for investment tips from its research.
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The size of the fixed-income research market is hard to assess. The Financial Conduct Authority has estimated that U.K. investment managers pay about 3 billion pounds ($3.9 billion) of dealing commissions a year to brokers, with about half this amount spent on research. Far less research is produced and consumed for fixed income than for equities, so payments are likely to be much smaller, according to the FCA.
Globally, secondary equity commissions are worth about $30 billion a year, of which $20 billion is spent on research, according to a report by Bloomberg Intelligence, Frost Consulting, Edison Investment Research and Edison Group. Following the FCA’s logic, fixed-income is probably a fraction of that.
In equities trades, brokers’ commissions can be dissected to come up with a research charge. Applying that approach to fixed-income trades isn’t straightforward, but regulators say it can be done. The FCA says the cost is “embedded within the negotiable bid/offer spreads quoted by brokers” and if it is a “material part of a broker’s costs, we would expect a narrowing of spreads.”
Mark Holman, chief executive officer of TwentyFour Asset Management, shares the industry’s skepticism. “The spread is the level that the dealer is willing to deal at regardless of the research,” he said. “If you happen to produce research, it has absolutely nothing to do with the bid-offer spread.”
“This will bring higher administrative and compliance costs and the burden will be all on the buy side,” said Mark Wade, head of industrials and utilities research at Allianz Global Investors. “It could also mean wider bid-offer spreads at a time when our fees are under pressure.”
So what will happen on Jan. 3, when MiFID II goes live?
For a start, asset managers are likely to be more choosy about research across the board. Demand for fixed-income research could also dwindle because many products aren’t “research dependent,” according to Greenwich Associates. “In credit products, research may be provided but fall into the ‘nice to have’ bucket, rather than being a critical component of investment decision-making,” the consultancy said in a report.
If spreads don’t narrow as the regulators predict, it could even be argued that investors are paying twice — once in the spread, a second time in cash, said Simon Adamson, an analyst at CreditSights, an independent research house.
“People are concerned they’re already paying for research somewhere,” Adamson said. “If you charge separately for it, then you’re arguably asking them to pay for it on top.”
Whatever price the banks settle on by the start of the year, investors won’t take that as the final word, according to Ross Barrett, a capital-markets specialist at The Investment Association, which represents U.K. investment managers. And it may emerge that fixed-income research is just the cost of doing business, an ancillary product that demonstrates brokers’ knowledge of the market, he said.
“If a broker says, ‘Look, you must pay us 150,000 a year for our fixed-income research,’ let’s see how many asset managers sign up for that,” Barrett said. A year into the new system, asset managers that have signed contracts for research will start to ask what value it has delivered. “It’s not just ‘What’s the price year one,’ it’s also ‘What’s the price year two.’ This might take a couple of years before it settles down.”