#mifid

Why the broking industry doesn’t get it and the regulator gets it even less

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I’ve had the opportunity to speak to numerous brokers in recent weeks and the sad fact remains much of the strategy is stuck in yesteryear. The idea that hiring more analysts and promoting a full deck colour brochure of their supposed ‘depth’ to clients is somehow more important than the content they can actually provide in a dumbed down compliance constrained world. The game has changed. The regulator has even less understanding than the brokers when it comes to understanding client needs. The buy-side investment community is also becoming highly resource constrained. To have to waste countless hours on admin to set a price on increasingly valueless research does them no favours.

Don’t be fooled by Smart Karma or Research Pool or any other 3rd party research aggregator. It is the same dumbed-down research bundled into a convenient pricing structure. I’ve looked into the economics and unless a research provider has a huge following the returns on contributing to these third party platforms is next to worthless. The more mouths to feed, the less return. On top of that the platform has no real control over what goes into it. It is a convenience store but in that vein, the nutritional value remains relatively low.

The simplest form of strategy is to set up ‘Special Forces’ type research teams. These teams don’t write rated research but charge on a ‘per mission’ basis. Take GLG. They have no broking license but carry out bespoke requests. Why aren’t brokers following this model? It is insane to hire more in sales, research and trading when the regulator is squeezing the traditional proposition to zero.

Two questions:

Did regulators actually ask smaller scale institutional  investors what they needed before they imposed rules which will dramatically increase their cost of doing business, the very opposite of the goal the regulator thinks its rules will create?

Are the traders of risk willing to take any risk to fill a gaping hole the very people they proclaim they serve are crying for?

What I see is more of the same. The bunker mentality. Conforming to outdated models to keep their inflated salaries alive for as long as possible pandering to internal politics to survive. Badgering clients to fill in irrelevant polls which serve no purpose but the promise of magical commission dollars in the future to their out of touch bosses at HQ. Some brokers even publish “the best of research” weeklies as a sort of self-appraised quality control mechanism to push on clients. Let’s think about that. If all research was properly screened before being published there would be no need to tell clients that this is the tiny fraction of research that isn’t (supposed) rubbish. It is actually confirming client’s worst fears – sell-side brokers aren’t listening  (as usual).

The gig is up. Regulators are even more clueless. Instead of trying to provide a marketplace where smaller boutiques can survive they drive the cost of compliance to such a degree that in many cases the teams of internal watchdogs swamps the investment decision makers. That’s right! The hottest ticket in finance is in compliance. A headhunter told me the network of compliance officers is so tight across firms there is almost a deliberate ‘insider’ matrix among them which encourages them all to switch firms to keep driving up their ‘collective’ remuneration. The people in charge of preventing scams are in fact the biggest operator of insider trading!

We’ve countless examples of how inept regulators are. Bernie Maddoff the biggest of them all. Despite multiple investigations and the clearest set of breaches presented to them they failed to uncover a $65bn fraud. Many regulators by background are lawyers meaning they are full of theory but devoid of real world practice. Regulators would be better off hiring convicted traders to hunt down fraud and illegal behaviour. As it stands they are as clueless as ever thinking more biting regulations will help the market. Wrong. Free it up but raise the penalties for actual wrong doing. I’ve never met an investor who doesn’t want to keep a useful broker alive. That’s why the payment skew is like it is. It isn’t just about Michelin 3-star meals and strip clubs. All the regulator has done is make an uncomplicated system almost unworkable. Although if brokers woke up to the fact that providing ‘special forces’ that clients directly requested and paid for they’d fill a gap which the regultor would have no answer to and make the iTunes research fintech companies obsolete overnight.

MiFID 2 will be the crowning glory of regulatory failure. MiFID 3 will be here before we know it as evidence of the catastrophic bungle it’s predecessor already is before it is in effect. Then again it is an EU directive – that ought to have told us something.

The problem with regulators – if you want to stop crime, employ convicts

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While the investment research community was already dying from its own self-inflicted wounds the regulators in the EU have more or less grabbed the back of the head of the investment banks and investors and drowned them in more regulation which will kill them off. Instead of asking the investment managers what they valued, the regulators have now sought to “price” value, something they know little to nothing about.

Had it occurred to regulators that what little value added that remains in the system, it is somewhat counter productive to prevent a broker from putting forward a unique piece of research that the client doesn’t actually know they don’t know but could end up being even more valuable because after all price discovery is what markets are all about? However if the broker can’t promote it, what chance has the investment manager got to discover it? Shouldn’t it be up to the client to decide what they receive? If a broker wants to send free research because that is the value they put to it, isn’t it the same thing as a coffee shop offering free samples in the hopes you may go into the store and buy one? Shouldn’t Starbucks be banned from offering free samples ‘unsolicited’ to innocent pedestrians if brokers can’t peddle free research? The client can filter garbage from their side without regulation. Software is sophisticated.

However isn’t this the rub? Clients and brokers are unique in different ways. That is why they attract different customers who like their risk/reward profiles. Some clients need bigger trading capabilities of which they are willing to pay a bigger price for. Some have no need for research but given the heavy participation by the central banks in distorting free market behavior find the need to concentrate their trading. What might look like blatant favouritism is in actual fact a client’s way of protecting an efficient trading platform. Failure to do so could lead to the disruption of that service which in turn will add unnecessary transaction costs which ends up impacting the clients the regulators are seeking to protect.

Also how can a regulator properly price quality? Quantity and box ticking is a broker forte but clients may find a meeting with a sell side analyst was worth $100,000 not the $1,000 the regulator is trying to standardize. It may have been worth minus $10,000 if the meeting added no value. Qualitative aspects of services are very hard to quantify yet the regulator thinks he or she knows better.

Yes, pretty much everyone gets that front running, illegal insider trading and unscrupulous behavior can’t be tolerated and must be met with the strictest punishment. However telling an investor that he or she can’t consume what they want and how they want it beggars belief. It is regulation gone too far. The regulator needs to stop employing underachieving law graduates who don’t understand markets.

If you want vigilance, employ from within the firms – hire convicted traders who can spot an anomaly in an instant rather than a clueless bureaucrat who acts as if he knows what he doesn’t. Don’t laugh. Investment analyst Harry Markopoulos busted the Bernie Madoff Ponzi scheme 5 years before it blew up. He gave the SEC the most basic detailed reasons even a toddler could understand and after three investigations the SEC still couldn’t work it out. 

The SEC even said after its admonishment the following:

The Office of the Inspector General (OIG) investigation did find, however, that the SEC received more than ample information in the form of detailed and substantive complaints over the years to warrant a thorough and comprehensive examination and/or investigation of Bernard Madoff and BMIS for operating a Ponzi scheme, and that despite three examinations and two investigations being conducted, a thorough and competent investigation or examination was never performed.”

Instead of receiving a stipend from the treasury, regulators should get higher access/user fees from market participants so they can run multi-year budgets properly, hire decent people at market rates and invest in maintaining stable, orderly and functional markets. Market integrity is the game. Slapping on excess and onerous compliance costs stifles activity.

Industry associations are behind paying higher fees. Rick A. Fleming of the SEC’s Investor Advocate said in August 2014, “To some, the idea of a “user fee” sounds a lot like a tax. But several industry associations that represent investment advisers have actually endorsed the concept of user fees. They recognize that a rogue adviser not only harms investors, but also leaves a stain on the advisory industry, so they support an increased regulatory presence and are willing to pay for it. Let me repeat that – they are willing to pay more money to the SEC so that it can conduct more examinations of advisers.”

So to Europe’s new MiFID rules.

European Authorities have published new details on the implementation of Research Unbundling as of Jan 18, 2017.

Unsolicited research can’t be accepted by Investment Managers based in Europe anymore. Providers (Investment banks, brokers, independents) will have to stop sending them research content that is not directly paid for.

“It is not acceptable for firms to receive research for free where no assessment has been made under the above inducements rules or there is no payment arrangement in place that complies with Article 13 of the MiFID II Delegated Directive.”

European Investment Managers have to comply with unbundling regardless of the location of the research providers (investment banks, brokers, independents). If they want to service them, they have to supply and price execution and research services separately.

“EU/EEA firms subject to MiFID II inducements rules must comply with these requirements (Article 24, paragraphs (7), (8) and (9), and the relevant level two provisions) irrespective of the status or geographical location of the research provider”

Sponsored research (commissioned by the issuer) can’t be paid for by investment firms based in Europe. This research needs to be made available to all investment firms at the same time.

If Europe wishes to completely bury the industry, they’re going the right way about it.