The “Capital Markets” division within every investment bank is constantly evolving and adapting to the world of geopolitics. After the financial crisis, Europe has taken the lead in imposing a very strict protocol to enhance transparency and investor protection. The newest iteration of this regime is known as the “Markets in Financial Instruments Directive,” or “MiFID2.”It is imperative to understand the potential regulatory changes, and have a plan to execute in the future. At Wedbush, we are already moving towards a structure that will give us the best opportunity for success.
"Payment for research will need to be totally unbundled from trading commissions used for ‘best execution"
Rather than go into all the background behind these new regulations, it’s more useful to focus on the scope of this directive, its key tenets, and how a firm like Wedbush can adapt its capital markets business to meet these challenges, and use the changing landscape as an opportunity to gain share, and improve profitability.
After some bumps along the way, MiFID2 is scheduled to take effect on January 3, 2018. MiFID2 applies to any European Investment Bank, or Asset Manager, with European investors.
Wedbush is an investment bank based in Los Angeles. Why should we care what happens in Europe? We should care, because most large U.S. asset managers have European investors, and will be required to apply these new regulations to any assets managed on behalf of European clients.
The SEC and United States regulators have been rather quiet, in comparison, to Europe, which begs the next question: How important is this really going to be for U.S. focused investment banks? It is very important, because many global asset managers are not going to segregate their investors, and instead will apply the strictest regulations to all their assets, regardless of the domicile of the investor.
The key tenet of these new regulations is to enhance investor protection. To achieve this goal, MiFID2 specifies that the use of dealing commissions and the consumption of research will be heavily restricted. Essentially, payment for research will need to be totally unbundled from trading commissions used for “best execution”.
In the current Capital Markets model:
1. A firm can pay for research via commissions from trade execution with the investment bank, or by writing a check to the investment bank. In the future, asset managers subject to MiFID2 can only pay for research by check. In order to pay for research, an asset manager must pay for the research directly from its own resources, or via a separate Research Payment Account (RPA), funded by a specific charge to the client.
2. An asset manager executes with different investment banks in order to pay for research and/ or to satisfy “best-execution” requirements. In the future, asset managers subject to MiFID2, can only execute with brokers who provide them “best-execution,” irrespective of research.
3. An asset manager will pay an investment bank for “corporate access,” by trading commissions or by check. The mandates under MiFID2 do not speak specifically to “corporate access,” but as Simmons & Simmons said in their review of MiFID2: “The language of the directive which explains the types of research that are eligible for payment via the RPA solution, is inconsistent with the corporate access concept, suggesting very strongly that corporate access will now need to be paid for by managers from their own balance sheet.”
To say these are revolutionary changes in the way capital markets divisions have conducted their businesses, would be a tremendous understatement. Asset managers will be laser focused on assessing the true value of “sell-side” research, the true “best-execution” vendors, and the value of a meeting with corporate management. Add to the mix the fact that an asset manager will have to fund these research payments through their own balance sheet, or an extra charge to clients, and suddenly everyone one learns really fast what actually makes a difference in the investment process of the client.
As the Co-Head of Equities at Wedbush Securities, I have spent quite a bit of time thinking about how a firm of our size can succeed in the aforementioned environment. In a word: specialization. I have told every colleague who is an analyst, it is imperative the analyst is one of the top ten in his or her vertical. I have told every colleague in distribution, it is essential he or she is one of the top ten salespeople, or trader, covering each account. In order to succeed in this environment, the client must identify our firm as a specialist in a specific vertical, or a great trading firm, in a subset of stocks. We have made great strides to only focus on the battles we can win, and to walk away from areas where we cannot compete.
We still believe that if we can help the client make money, we will succeed. The client base will be much more discerning, and deliberate in how they spend every dollar, and we, as a division of “Capital Markets” at Wedbush, need to ensure we are providing quality resources and execution to warrant those client payments.
When all is said and done, it will be survival of the most adaptable. Wedbush Capital Markets is focused on being narrow and deep, so that each time the client calls, he or she knows exactly why Wedbush is the best choice for that specific service. That is why we are not miffed about MiFID2. Instead, we see a huge opportunity to take share, and be an even more important part of our clients’ investment process.