Written by John D’Antona Jr.
Research. Financial CHOICE Act.
Two great propositions that go great together?
Research is an integral part of the trading process. Making the right choice in which to select, how to implement and execute completes that methodology. The U.S. equity market structure is among the most dynamic and fluid, if not the most complicated in the world. And in the next six to 18 months, it could see a pair of new regulations or statutes that could be the most significant since the implementation of Regulation NMS on July 10, 2007. These two rules – the Markets in Financial Instruments Directive II, set to go into effect in January and the Financial CHOICE Act, which is currently making its way in bill form through Congress – could shape the way traders and the sell-side conduct business into the foreseeable future.
In looking at MiFID II, which is a result of the European Securities and Markets Authority, has global implications despite its origins. The rule applies to all firms that trade in European markets, which includes but is not limited to the U.S. The rule mandates that sell-side brokers can no longer bundle execution and research costs into one lump payment. Rather, both are separate costs and must be publicly disclosed to promote market transparency and accountability.
MiFID II most prominent effect is on the research, namely how it is paid for and just how much is actually paid. For traders, regardless of jurisdiction, research drives the trading bus and anything that affects its provision is cause for concern.
Specifically, MiFID II states that Investment firms should account for research as a fixed, predictable cost, not linked to execution costs or otherwise subsidized. Also, the cost of research should be either be a core management cost or be fully transparent to investors, thus removing any conflict of interest. Lastly, a transparent, priced market should emerge where the cost of research is linked to the quality and quantity of goods and services supplied (and the value derived to investors).
The Financial CHOICE Act is a slightly different animal than its MiFID counterpart. First, CHOICE is a response to the Dodd Frank Act and not a continuation like MiFID II. Also, CHOICE (as of this writing) is not law and has no implementation date – rather after just passing a full House vote in bill form until the Senate decides what to do. The CHOICE Act faces an uncertain future in the Senate where Democrats are broadly opposed to the legislation and their votes are needed to pass it.
The bill, authored by Representative Jeb Hensarling (R-Texas), would repeal large portions of Dodd-Frank, while placing significant new restrictions on financial regulators like the Consumer Financial Protection Bureau. It would allow banks to opt out of Dodd-Frank if they hold enough cash, and it would limit federal stress tests of major banks to every two years. The bill would remove the power through which the federal government can label a bank “too big to fail,” and disassemble it before it collapses and triggers another crisis. The bill would also replace Dodd-Frank’s Orderly Liquidation Authority with a special bankruptcy process that aims to insulate the financial markets from a failing bank’s fallout.Republican sponsors and supporters of the bill have insisted that their bill will be tougher on the financial sector by removing Dodd-Frank safeguards they say encourage risky behavior. Democrats are certain to oppose the bill, at least in its current form, as they feel it caters to Wall Street and removes the safeguards that protect individuals -such as reducing the frequency of federal stress tests and restrain oversights powers of several federal agencies that the 2010 law expanded.
When it comes to MiFID II, its effects on research and trading has given rise to a cottage industry of vendor-provided solutions and a global push for compliance. Both in the U.S. and abroad, vendors and some sell-side firms are all looking to cater to the buy-sides’ need for compliance with the rule, which according to market consultancy Greenwich Associates, could trim research spending by institutions by as much as $300 million.
But that’s not all. MiFID II could cost the research industry jobs and business, as a bifurcation among research providers is sure to happen as top providers with deep pockets have a better chance of survival and compliance while smaller boutique firms could face more difficult times – including downsizing or even closure.
A new Greenwich report, “The Impact of MiFID II on Equity Trading,” presents the results of a March/April 2017 study in which the consultancy interviewed 55 buy-side traders and head traders based in Europe about expected changes to their trading workflow following the implementation of the MiFID II regulations in 2018.
“More than half of traders in continental Europe are either undecided on what changes they need to make or are awaiting further clarity” said Richard Johnson, Vice President of Market Structure and Technology at Greenwich Associates and author of the report. “This suggests there will be a significant rush to comply and make changes in the second half of 2017.”First, the revamped broker evaluation process in Europe appears likely to create some fallout in broker lists. The traders in the study expect to reduce the number of brokers they use by almost two brokers on average. Despite the net reduction in broker lists, specialist electronic brokers are expected to see an increased level of business.
Also, buy-sider expect MiFID II unbundling rules to drive a shift toward low-touch electronic execution channels. More than 40% of the traders expect to increase usage of algorithmic trading, while just 4% expect a decrease. “And despite MiFID II rules being designed specifically to reduce dark pool trading, traders actually expect to increase usage-with 10% expecting a significant increase,” Johnson noted.
And let’s not forget the post-trade implications. As research is removed from the picture, the results of internal transaction cost analysis (TCA) will be the number-one determinant of where to route trade orders, according to the traders in the study. TCA results will also play a key role in meeting MiFID II’s beefed up best execution rules. More than two-thirds of European buy-side traders expect to increase their usage of TCA next year, and almost half expect to review their TCA system to ensure they have the best tools to allow them to comply with the new MiFID II guidelines on TCA.
Do We Have a CHOICE?
The CHOICE Act is certain to be subject to revision by committee, as Democrats in the Senate won’t even look at the bill in its present form. That says nothing as any adjustment by the Senate and passage there would require a reconciliation of the House and Senate bills before it can be looked at by the Congress before being put before the President for signing. This could take quite some time as Congress prepares for its summer hiatus and there are no plans currently for the Senate to look at it.
And the opposition isn’t just from Congress – but others as well.
“The CHOICE Act would dismantle important shareholder rights, make investing in public companies riskier and undercut the ability of the SEC to protect investors,” CII Executive Director Ken Bertsch said in an emailed statement.
The Final Word
These two single regulations (including CHOICE if passed) are sure to have a tremendous impact on the financial markets. But one thing is for sure, research still drives the trading execution bus and the markets always have a choice – obey regulations or not. Let’s help the industry do the proper due diligence and research in order to make the best choice.
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