MiFID II and Unintended Consequences

It’s 2020 and it feels like this is going to be the year of change. While 2019 definitely had a lot of change, it still felt like there was ‘resistance’ – I put it in quotes because it’s hard to define, but it felt to me like some people were still holding onto the old world of institutional finance. It felt like there were people who thought things would go back to the way they were. The new year, and the new decade, and the fact that it’s 2020 seems to have changed that. I can feel a general acceptance around the table that the world is changing, and a new shift to looking forward to new shores, instead of looking back and trying to keep our eyes on an ever disappearing land.

I have a number of thoughts about what 2020 holds in store (which I’m still working on), but I think one of the biggest themes will be a lot of recent changes ‘flushing out’ – there has been a lot of new initiatives in the industry over the last few years, and 2020 feels like it’s the year that they flush themselves out – including the impact of the intended consequences, but also the impact of the unintended ones.

Let’s look at MiFID II as an example. That piece of legislation was predicted to have a monumental impact on the industry – among other parts, it was set to fundamentally unpack and unbundle the connection between research and execution. New businesses and platforms were started to facilitate that new world order – research marketplaces, commission management systems, interaction recording tools. Now, a few years in, we see that while the impact is definitely there, it was less than expected – the industry didn’t change overnight and everything hasn’t unbundled just yet. In fact, with Brexit on the horizon, it looks like there is increasing appetite by the remaining EU parties to revisit the fundamental tenets of MiFID II (including unbundling), and an increasing view that the impact of the regulation has largely been negative.

One of the impacts that is front and center is the declining amount of coverage, especially outside the large and mega-cap names. Yes, Apple will always have plenty of coverage – but what about everyone else? The number of covering analysts is declining in almost every other corporate segment. What does that mean? There is less ‘information absorption and processing’ happening with those companies. If a company had 10 analysts covering it, and now has 5, that means that there are half the number of people actively absorbing, processing, writing, and sharing insights and information on the company. That means the story won’t be as broadly or deeply understood, everything being equal. It also means that ‘unexpected’ events are more likely to happen. Earnings will surprise, or underwhelm. Numbers will be different than expected, as models become out-dated. The markets will react more.

What does that mean? More volatility – and it seems like some participants couldn’t be happier. As the WSJ highlighted, hedge funds are finding more opportunities as coverage drops among mid-cap and small-cap companies. To paraphrase the quote, it seems that “one group’s regulation is another group’s opportunity.”

When the regulators put together MiFID II, I’m sure they had the best of intentions, and they thought deeply about the consequences. They may or may not have seen the impact the regulation would have on research coverage levels, but that was a semi-predictable impact. What they likely did not see at all was the resulting price volatility it would create within those companies, as coverage fell. I don’t think anyone believes that this regulation was intended to give active managers an olive branch, but it has created opportunities for savvy, timely investors to find alpha. However, it has also created challenges for the companies themselves, as they find it harder and harder to communicate with the market, share important updates, and connect with investors. In an era of increasing regulation, it’s not the intended consequences that you have to watch out for – it’s the unintended and indirect ones.

I believe that we’ll continue to see these second or third derivative impacts this year from regulatory changes over the last few years, evolving market structures, and industry pressures. The good news is that everyone now seems to be fully committed to looking ahead, and planning for the future – 2020 looks like it will be one of the most exciting years to date. I personally cannot wait to see how it unfolds.

Happy 2020, and as always, we’re here to help!

Blair Livingston
Street Contxt

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