Macquarie's equity research team has just offered up a valuable economics lesson which seems to perfectly, if inconveniently, explain why their business model is doomed by the upcoming implementation of MiFID II.
So what happens when you compete in a 'slightly' fragmented market (see below) to sell a highly commoditized product to a customer that places so little value on the product that it has historically only existed courtesy of subsidies from trading revenues...then a regulatory body suddenly comes along and says you have survive as an independent operation?
Well, as Macquarie notes today, almost everyone, particularly those in an equity research group, loses.
As equity research analysts, we can’t close the review of MiFID II implementation without discussing the implications of research unbundling, by which asset managers will have to pay separately for execution and trading. Here are a few points that have emerged as consensual on a number of white papers and articles:
- P&L method over RPA. An increasingly large number of leading asset managers already announced they will internalise the cost of research in their P&L instead of charging it separately to investors via Research Payment Accounts that are seen as overly cumbersome to implement. The list includes, in alphabetical order, Allianz Global, Aviva, Axa IM, BlackRock, Deutsche AM, Franklin Templeton, HSBC AM, Invesco, Janus Henderson, JPMorgan AM, M&G, Robeco, Schroders, Standard Life, T Rowe Price, UBS and Union (please see live list here).
- Research budget cuts. A McKinsey report estimated a 10-30% reduction in buy side’s external payment for research over the next three years, while an S&P survey indicates a 10-15% increase in internal research budget.
- Run to the bottom on pricing – a number of FT articles indicate bulge brackets demanded a minimum payment of up to £300-400k/year for access to written research, but that has decreased significantly. JPMorgan is reportedly offering entry level access for $10k/year and Jefferies will offer its research for free, not to jeopardise banking revenues.
According to the S&P survey mentioned above, asset managers’ EBIT may decline by 15%/ 30% as a result of the shift to P&L accounting for external research. In any case it is clear that both buy side and sell side are involved in the consumption and production of research will see a decrease in profitability and may seek cost savings, continuing the gloomy trend in headcount decline highlighted in Fig 5-6.
Meanwhile, Macquarie highlights the fact that the upcoming implementation of MiFID II will only add to the complete decimation of the financial industry that has already lost 1,000's of jobs over the past 6 years.
According to a recent report by Coalition (Fig 5), front office headcounts declined 21% since 2011, in spite of a generally supportive macro environment. The data show a much harder decline in FICC (-32%) compared to -12% to -14% for Equity and Advisory. Part of the decline may be explained with business cycle, but we believe an acceleration in the shift to electronic trading is also at play.
Lastly, data compiled specifically by McKinsey on the Equities segment of the top 9 investment banks show that sales and trading headcount declined three times faster than research since 2011 (Fig 6). For example, Goldman Sachs’ US cash equities business moved from 600 traders in year 2000 to only 2 traders in 2016, plus 200 programmers.
Finally, for those who have managed to avoid this particular distraction and have no idea what MiFID II is, the global equity research industry is in the midst of a major disruption which has been brought on by the European Union’s MiFID II regulations, enforced from Jan. 3, which aim to tackle conflicts of interest by requiring asset managers to separate the trading commissions they pay from investment-research fees.
Of course, the biggest problem with such a regulation continues to be that literally no one knows the true 'value' of equity research, not even the investment banks that are selling it. Meanwhile, we're almost certain that hedge funds don't feel the need to buy 50 different versions of a research report on the same company that can all be summarized in four words: "Buy The Fucking Dip."