MiFID II implications on Investment Research. Avoiding price wars and focussing on value is key for the success of the industry in a post-MiFID II world.
The Research industry is at a pivotal moment due to the imminent implementation of the MIFID II regulation. There is a widespread view that this will disrupt the industry, bringing down profitability. However, Simon-Kucher & Partners believes that there will always be a need for high quality research and that the players who adopt a smart differentiation strategy will stand out from their competition, increase market share and generate better profits.
January 3rd 2018 is a seismic day for the Investment Research industry which will experience a radical change in the very fundamentals of its business model.
From this date the new MiFID II regulations require buy-side clients(i.e. Asset Managers and Hedge Funds) to pay an unbundled commission for purchasing Research products and services, clearly separated from execution fees. The current logic ‘I will give you the research for free, if you trade with me’ won’t be applicable anymore and will instead be considered as a prohibited ‘inducement to trade’.
Until now, research has effectively never been priced and sold as standalone product. Separating research from trading is likely to push the industry into a period of discovery and intense negotiations among players in the market since there is no reference point to begin the contractual discussions. Consequently, banks are facing a situation often seen far more frequently outside financial services – the launch of a new product in the market.
There is an increasing concern that the result of this fundamental shift in perspective will ultimately trim banks’ profits and cause significant consolidation in the industry, reducing the number of research providers.
After the discovery phase, as the research products become more and more ‘mature’, the expected status quo situation will likely see the emergence of a handful of global research providers on the one hand and on the other a number of specialised players that defend a market niche. Those stuck in the middle will ultimately need to decide whether to step up their investments to join the first group or to devote all their resources to create their own niche. In any case, there seems to be no room for everyone and, for those who make it, profits won’t probably return to pre-MiFID II levels.
Although the overall picture looks gloomy, we at Simon-Kucher & Partners think that not all hope is lost! Far from it. Even accounting for the extreme industry consolidation scenario happening, which it may not, we are convinced that this will in the end increase the willingness of buy-side institutions to pay for high-quality services.
And if the buyers are willing to pay more for quality, banks need to position themselves so they can price accordingly… which can be easier said than done without a clear strategy and strong buyer insights.
Of course, from the perspective of the bankers on the sell-side, their clients have a high bargaining power and will use it to extract favourable conditions. However, even buy-side firms have a lot to lose if they are not careful and push too hard for price reductions that hit the quality of the research.
Ultimately, Investment Banking is a relationship-based industry and it will always remain so. Relationships between banks and asset managers are so intertwined that the negotiations around research costs will always take into consideration the big picture. Buy-side firms, for example, have to evaluate the trade-off between paying a higher price on research or burning bridges completely,risking the loss off a preferential channel for capital raises or bond emissions.
However, in the new world quality will take on more importance than it did previously. When everything was free of charge, quality didn’t really represent a factor in decision-making. Next year, when funds’ or consumers’ money will be spent for purchasing research, the classic demand and supply dynamic will become prominent. If the content generated by a sell-side provider is considered of better quality, demand for it will increase, and considering a limited supply, price will necessarily rise and so will profitability.
Investment banks must not make the mistake of considering their research products as ‘commodities’. This is the key for transforming the challenge ahead into an opportunity. Research should not be perceived solely as a report, an analyst call or a visit to a CEO, but rather as the process for generating investment ideas, and ideas have tremendous value.
Unfortunately, history doesn’t seem to have been favourable to players that have gone through a situation similar to that which banks now face. In similar instances the existing players’ fear of losing market share has led many industries into damaging price wars. It will be bad news for banks if they too launch into the mutually assured profit destruction of tit-for-tat prices cuts that will ultimately see valuable research sold at Pound land prices.
Simon-Kucher & Partners’ 2016 global pricing survey of more than 300 bankers across 25 countries found that the majority of the respondents acknowledge that their industry is undergoing a price war. What’s even more interesting is that 89% of respondents blamed their competitors for triggering it. The thinking is ‘they started it, we can only follow suit by decreasing our prices’. This is exactly how the commoditisation process begins and when prices go down it is extremely difficult, if not impossible, to bring them back up.
Global leaders in the sell-side space should ponder whether crushing competitors with extremely low prices is the right strategy or is it better to resist the temptation and keep prices economically sustainable. Competition dynamics are multi-faceted – a bank might be ranked top-3 in a particular asset class, but fall below the top-10 in another one. An aggressive strategy in one asset class is necessarily going to trigger a retaliation somewhere else, thereby contributing to lower profit levels for every provider.
In our opinion, banks need to face the regulatory challenge by simultaneously assessing their relative strengths vis-a-vis their competitors, and quantify the value they deliver to buy-side clients. Focussing on the value delivered from their research, and measuring the relative power to charge a fair price for it is key in ensuring a profitable future for the industry.
In this transition year, it will be of outmost importance for investment bankers to focus on their negotiation capabilities to strike satisfactory deals during talks with asset managers and hedge funds. Having a clear view of the overall profitability of the relationship with the buy-side will also be important in avoiding disruptions in other businesses that banks have with the same clients.