MiFID 2 and equity research – don’t forget the internal clients
Equity research has been expecting the worst ever since it became clear last year that the European Commission was not going to compromise on a set of research rules which were widely regarded in the industry as being unworkable. Fund
managers now effectively have to pay for research out of their own P&L, rather than out of trading commissions, and the signs are that they are being more choosy about what they pay for.
At a conference last week, J.P. Morgan’s Dan Pinto suggested that research revenues have already fallen 25%, and that “another leg down” is likely. So does this mean more redundancies and less hiring?
Not necessarily. It is noticeable that despite these projections, Pinto is not currently planning any headcount reductions in J.P. Morgan’s own European equity research. There are two potential reasons why the more pessimistic industry observers might be exaggerating the potential effect of MiFID revenue losses.
First, a lot of the cost cutting work has already been done. When the MiFID unbundling rules were first floated, back in 2013, there were still plenty of marginal players in the industry, and cost bases had not fully adjusted from the pre-crisis days. Five years of falling turnover, ever narrower commissions and spreads, and little primary activity have cut out nearly all the fat from equity research and quite a lot of the lean meat. It’s quite likely that from here on in, the only revenue fluctuations which will make a difference are the ones which drive players out of the industry altogether, as plenty of firms are operating close to minimum efficient scale.
A 25% yoy decline in research revenues in Europe sounds pretty awful, but in many firms it just means that revenues in 2018 are somewhere near 2013 levels, with a lower headcount.
But perhaps more importantly, the measurable revenues for equity research are only the external revenues. And it’s always been the case that many of the most important clients of a bank’s research department are internal. It’s hard to do capital markets deals without analysts, for example, and equity derivatives trading operations are big consumers of research in order to price dividend swaps and other products. Analysts have always provided significant amounts of services to the rest of the bank – if nothing else, they are the keepers and creators of the incredibly valuable consensus forecasts. If you are running a big market making desk or dealing in size with hedge fund clients, you only need to make a few big mistakes from using a stale set of numbers or missing a key insight from a conference call, and you can lose sums of money which would pay a couple of analyst salaries in less than half an hour.
With overall equity sales and trading revenues up by around 10% yoy in Q1 18 and significant investment going into derivatives at places like Credit Suisse, it’s not obvious that the true demand for good equity analysis has fallen anything like as much as the directly attributable revenues might suggest.
Which suggests that for those who kept their jobs, MiFID 2 might actually be good news for the future. It has knocked out a lot of the industry’s structural overcapacity, while locking in a certain “keep the lights on” level of revenue as a baseline from clients who are now committed to pay at this floor level no matter what happens to turnover. And now the direct fees for research are directly attributable to analysts, without necessarily reducing their claim on a share of the profits generated by trading, capital markets, wealth management, prime brokerage and all the other departments who ring up for “a bit of colour” every now and then.
So, when you hear the latest conference speeches and presentations telling you how far and fast equity research revenues are falling, it’s worth remembering a few things before looking for a job in another sector. First, the cost base is lower too. Second, those directed commissions were always shared with sales, and it very much looks like that’s where the worst of the impact is being felt. But finally, and most importantly, any analyst with any sense has always known that her
number one client is her own dealing desk, and it’s the internal clients that the pessimists are missing.
If you’re at JPM equity research and feeling vulnerable then remember - as long as there is just one person who values your opinion, and as long as he’s Dan Pinto, you’re all right.
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Dan Davies, is a senior research advisor at Frontline Analysts and a former banking analyst at Cazenove, Credit Suisse and BNP Paribas.