The EU's revised Markets in Financial Instruments Directive, or MiFID II, has created something of a level playing field on the research sell side, providing opportunities to independent research providers to take market share from bigger players, according to one equity research firm.

Since the reforms were introduced in January 2018, investment firms have been required to pay for research as a product separate from execution services. As a result many buy-side companies reduced their research budgets, while on the sell side large investment banks lowered prices for their research to protect their market share. This environment posed challenges for independent firms.

But the fact that investment managers must pay for research has made quality more important, according to Kunal Sawhney, CEO of equity research firm Kalkine. This allows independent firms like his, which target individual investors who generally struggle to find quality research, to better compete post-MiFID II, he told S&P Global Market Intelligence.

Growth opportunities

Sydney-headquartered Kalkine is an independent equity research firm providing recommendations on stocks across industries from banking and insurance to mining and technology. It serves retail investors and high-net-worth clients.

The company is looking to expand its geographical footprint: Having opened offices in Australia, New Zealand, Canada, and the U.K., it is now setting its sights on French-speaking Europe.

"With improving signs of economic growth, stable inflation and interest levels, optimistic demand scenario, improving the investment climate, the French countries offer a plethora of opportunities for companies to grow and scale up their business operations," Sawhney said.

Strong corporates operating in the safe and stable eurozone environment are attractive to investors and to new entrants in the research market such as Kalkine, he said.

IRPs vs. i-banks

Smaller independent research firms such as Kalkine had been seen as more vulnerable to the sweeping change the MiFID II framework brought about, as large buy- and sell-side players had to find new ways to price and trade research.

The previous practice was to bundle it together with execution services, which meant it had no specific price and was essentially considered a free addition to the services package.

The situation became more challenging generally for independent firms, according to Steve Kelly, a special adviser at the European Association of Independent Research Providers.

After the rules were introduced buy-side firms, such as large asset managers, cut the number of their research providers by 30% on average, he told S&P Global Market Intelligence.

Another somewhat unexpected consequence was that most asset managers decided to foot the bill for research themselves instead of charging clients through research payment accounts. As they made it part of their profit and loss accounts, these firms applied to research the same scrutiny as they did to any other expense item on their budget. Their budgets, which had started to fall already in 2018, dropped by some 20% on average in 2019, the European Association of Independent Research Providers' latest member survey indicates.

Many buy-side firms also reduced the number of their interactions with the sell side, cutting back on meetings, conference attendances or accepting research reports, as they were worried about misinterpreting some of the rules, Kelly said. Therefore, buy-side firms initially withdrew from anything they were not sure is in line with the new regulation, he said.

Unfair pricing

On the sell side, big investment banks started a race to the bottom in research pricing trying to protect their market share, compensating the lower price for research through cross-subsidizing it with other sides of their business, Kelly said.

The first move was made by JPMorgan Chase & Co. even before MIFID II was implemented when the biggest global investment bank said it would charge an annual fee of $10,000 for all of the research on its equities portal. This was a serious blow to pricing in the sector, according to Kelly.

The pricing practices of investment banks remain the main concern of independent research providers, of IRPs, which worry that the stiff price competition will harm their revenues. They have called on regulators to take "urgent action" on cross-subsidization.

But IRPs still have competitive advantages as they provide a more differentiated product, and cross-subsidization is not a sustainable practice in the long run, according to speakers at the Unbundling Uncovered conference in November 2019, organized by Substantive Research.

The European Association of Independent Research Providers' survey showed sector firms' revenues have remained relatively stable and their average headcount increased by 3% in 2019. The situation for IRPs has improved over the past six to nine months, Kelly said.

Research headcount at investment banks, on the other hand, has been on a steady decline since MIFID II was introduced. The global cash equities research headcount at the 12 leading global investment banks was 3,500 as of June 30, 2019, compared to 3,800 for full year 2018 and 3,900 in 2017, data from research firm Coalition shows.