Amid all the talk of London’s public markets slowdown, one unlikely route to bringing in more liquidity and listings is increasing analyst coverage of companies. The government has therefore launched a review aimed at helping the sector rebound after the European Union’s 2018 changes, which resulted in equity coverage by analysts falling.
The Markets in Financial Instruments Directive 2014 (known as Mifid II) came into place in order to limit bank and other financial institutions from drumming up business by handing out ‘free’ sell-side research, which was essentially paid for by bundling the cost of producing it in with executing trades.
The contested hypothesis is that this cut coverage of mid-cap companies, therefore reducing institutional investment and liquidity, ultimately lowering share prices due to reduced interest and awareness of investment cases.
City minister Andrew Griffith argued in a speech last week that more coverage would boost the London Stock Exchange.
“To ensure that the UK continues to be one of the best places for companies to list and trade, we need to ensure that investors have access to the information they need to make investment decisions,” he said. “The volume and quality of research matters. That translates into more liquid markets and can help obtain higher valuations.”
The review’s terms of reference put it in drier terms: “Low levels of investment research can... make it harder to value companies, make it more difficult for companies to attract investors, and make UK markets less attractive to businesses that want to raise capital.”
This also assumes all research will be making positive cases for investment – analysts also publish bear cases on companies and stick sell ratings on those they think are duds. Moreover, even the EU’s Mifid II rules can’t stop analysts from cosying up to management teams their banks are keen to do business with.
The Financial Conduct Authority (FCA), which was a driving force of the Mifid II reforms, has argued that the impact of unbundling was minor. It also removed restrictions for companies with market capitalisations of less than £200mn to prevent their liquidity from being impacted.
“Unbundling has improved the asset management and research market by reducing costs and conflicts of interest caused by inducements, and by improving competition for research and execution services to the benefit of the end-investor,” a 2021 FCA review found. “We therefore do not see merit in reversing the important benefits for investors that have arisen from such unbundling across a wider range of companies.”
In 2019, Andrew Bailey (then head of the FCA) forecast £1bn in savings for institutional investors over five years from the unbundling rules.
A new paper by academics from Harvard and the University of Michigan positioned Mifid II as a positive change in the investment space, compared with the continued bundling of research and brokerage services in the US. Its authors were sceptical that a relaxation of the rules would make an impact.
“British financial firms are unlikely to revert to unbundling practices irrespective of whether legal requirements are adjusted and, in the view of many [experts], this aspect of the Treasury’s review is unlikely to be advanced to the reform stage,” Howell E. Jackson and Jeffery Zhang said.
The authors did not come to a conclusion on whether Andrew Griffith’s view was right in their paper, although said bundled pre-Mifid II arrangements saw the “securities industry [exploit] information asymmetries to extract excess rents”. They added that a minority academic view "claims these arrangements are, in fact, efficient and may also improve the quality of capital markets".
Rachel Kent, a senior partner at law firm Hogan Lovells, is running the review, and is expected to report in just three months.
The inducement rules relate to sell-side analysts, who often work at banks or brokers and produce independent investment research. This is available to the firm’s clients. Mifid II put a price on this work (as well as meetings with analysts, and related services), rather than the ‘soft dollar’ approach where it is paid for through fees from the order flow generated by the research ideas. Buy-side analysts work in-house at asset managers, for example, and make recommendations internally. Jackson and Zhang said one response to Mifid II had been to increase buy-side research capabilities.
