The Long Arm of the (European) Law: MiFID II's Impact on Asia-Pacific

Being halfway around the world doesn’t mean that financial institutions in Asia are isolated from the impact of MiFID II, or any other regulation originating outside of Asia. Though Asia-based firms are affected to differing degrees, change is coming. 

Firms dealing with Europe either directly or indirectly will have to comply with the more expansive rules under MiFID II. One of the major headaches under the new set of rules which will come into effect on Jan. 3, 2018, is the unbundling of trading commissions from investment research payments, making research provision clearly distinct from commission payments—and jurisdictions outside Europe are no exception.

After 2018, buy-side firms will have to set up research payment accounts (RPAs) or work out a commission-sharing agreement (CSA) with their execution brokers. This is a big change for an industry that has traditionally paid for research via trading commissions, for which the payment amount is usually correlated to trade volumes. 

MiFID II requires the unbundling of research payments from execution payments and the former to be paid out of the investment manager’s own pocket unless the client expressly signs off on research being paid out of a special RPA funded by the client, says Eugenie Shen, managing director and head of asset management group at Asia Securities Industry and Financial Markets Association (ASIFMA).

“A lot of our clients felt they were not getting enough insight into companies across the region that really focused on their goals, which is to find investment ideas. That was the premise of our partnership with Smartkarma. But also certainly the underlying factor of this shift was MiFID II changes.” Stephane Loiseau, Societe Generale

In a recent study, agency broker ITG found that 82 percent of North American asset managers are looking to fully unbundle all of their brokers globally, though only 43 percent expect MiFID II to have a direct impact on them.

Although the study focused on asset managers in North America, Clare Witts, head of relationship management at ITG Asia-Pacific, says MiFID II will impact the industry globally, not just within Europe. 

“Our industry is not defined by regions anymore. There is a lot of money and business across borders. There are a number of asset managers in Asia-Pacific who—particularly if headquartered out of Europe—are choosing to apply European rules across their global business. This means that they are now going out to their sell-side brokers and trying to price the research being provided to them,” Witts says. 

This unbundling process will fundamentally change the commercial dynamic between the buy side and sell side in pricing and paying for research, but also reflects a shift within the investment banking industry, she adds, with fund managers using unbundling as a differentiator to attract new investors by showing they are more transparent and take better care of investors’ money because they price research clearly and aren’t spending on anything unnecessary.

“The push to change asset management practices in Asia is coming from the investors, competition for assets under management between asset managers, and will also come from brokers. Fund managers here are likely to either receive a request from an existing investor, miss out on attracting assets from a new investor, or be on the receiving end of a tougher commercial conversation with their research brokers than ever before,” Witts says.

This shift is evidenced by firms coming out of Hong Kong and Singapore that have shown interest in Societe Generale’s latest research initiative. At the end of 2016, SocGen partnered with Asian investment research and analysis firm Smartkarma to provide third-party independent Asian equity research to its clients worldwide, allowing—for a fee—SocGen’s clients to access Smartkarma’s platform, which provides access to more than 100 investment insight firms, with around 400 analysts in total. 

Apart from giving its clients access to Asian equity research, the bank believes the deal meets MiFID II’s unbundling requirements. A pre-determined portion of the commission rate clients pay the bank for trade execution will be allocated to fund their login to the platform. 

Stephane Loiseau, head of cash equities and global execution services for Asia-Pacific at SocGen, says most interest in the solution currently comes from funds in Hong Kong and Singapore, which may not be directly impacted by MiFID II. For about 18 months before the deal, SocGen—which did not have a source of stock research in the region—had been looking for a solution for institutional clients interested in Asian markets, he adds.

“A lot of our clients felt they were not getting enough insight into companies across the region that really focused on their goals, which is to find investment ideas. That was the premise of our partnership with Smartkarma. But also certainly the underlying factor of this shift was MiFID II changes,” Loiseau says.

Smartkarma chief executive and co-founder Raghav Kapoor says the company’s founding aim was to provide more transparent investment research to the market, in the face of an already-changing model for investment bank research, and to minimize the complexity of shifting to a new model that creates value and improves margins.

“While regulation certainly acts as a catalyst, it isn’t the only reason why the asset management industry is evolving in this direction. Everyone is going to be impacted by this, whether they are global multinational companies or smaller regional banks,” he says.

Loiseau says the solution is independent and therefore MiFID II-compliant, and meets the bank’s goal to provide its clients access to niche but in-depth research coverage. “We were trying to find something that was much wider in scope, as well as cost-effective for everyone. We wanted the solution to be compatible with regulations in different jurisdictions, not only MiFID II in Europe. Finally, we also wanted to look at technology as a way to deliver, seeing that the bank puts a heavy focus on anything fintech-savvy.”

Although the offering is unbundled, SocGen clients can still choose how they pay for it. In countries where clients want to use CSAs—or more bundled payments, since some can’t do physical unbundling—they would still be able to use the platform.

Basically, clients pay one rate for trading, one fee for research, and the payment would be in one amount, but the client would be able to separate the two on an accounting basis. “Therefore, clients that can’t do CSAs would still be able to have a clean audit trail,” Loiseau says.

However, David Landi, director of business development at research and analytics advisory firm The Smart Cube says he disagrees that unbundling is more of an industry-wide change. “In this instance, it goes without saying that MiFID II is the primary driver behind initiatives to unbundle research from transaction fees. The proposed regulatory changes have forced the hand of the investment banking industry, as it was required to react and rethink about how it is going to operate in order to work within the new compliance boundaries,” he says.

New Pricing Models

The move to unbundle may result in global brokers shutting down their research business in non-core regions, due to the challenges of monetizing research in the new environment. Many brokers are now reviewing whether their research remains commercially viable in a fixed-price environment, says ITG’s Witts. 

MiFID II requirements might prompt investment managers to cut back on buying external research since they are now expected to bear the cost, and could lead to more research being produced in-house, potentially resulting in increased management fees to cover the costs—something that concerns Asian regulators, adds ASIFMA’s Shen.

Large asset managers are already negotiating prices with their brokers in Europe. If research is being priced in Europe, Witts says those pricing models will then become de facto global pricing models, with the shake-out of that hitting Asia-Pacific in late 2017 and 2018. “Only then we will start to see the real implications of it,” she adds.

Investors are also getting involved in this process. European asset managers are already having conversations with investors about how much they pay for research. 

“Imagine if you are a sovereign wealth fund in Asia and have invested with a European fund manager. That manager is now saying, ‘Here’s my management fee, and here’s what I propose to spend on research.’ That investor might start looking across all their managers to see how they compare, and demand the same level of information,” Witts says.

This may result in investors wanting to standardize those reports from their European asset managers with their other asset managers globally. 

“I’ve heard anecdotally about managers in Asia who are not directly affected by the regulation at all—like a hedge fund in Hong Kong—receiving a question on this from one of their investors. So while they aren’t directly affected by MiFID II, the investor has asked them to provide a report that splits out research from trading,” she adds. 

Culture Clash

Different jurisdictions within Asia will also be affected differently. For example, the concept of CSAs or soft dollars is not common in Korea and Japan as it is not eligible under those regulatory regimes. So for local brokers with only local clients in those markets, the change won’t be significant, Witts says. 

“If you’re a Japanese asset manager and have international investors—such as if you receive money from a global pension fund that wants to access your domestic Japanese portfolio—then you are likely to get a question about how much of their money has been used to buy research, and what was bought. We would see the impact for those types of local managers as being more around reporting, being able to access that data, and having systems in place to demonstrate to the investor what that money was spent, and how,” she says.

Meanwhile, foreign brokers based in Japan will probably not cover Japanese stocks like they have in the past because they will not be able to monetize that effort. “If you are a foreign bank based in Japan, you’re providing Japanese research to Japanese and foreign clients. Suddenly those foreign clients won’t be consuming research in the same way. This means the bank will scale down those efforts to those clients, which means your budget and cost won’t be the same,” Loiseau says.

Still, there is value for good research in Asia-Pacific, due partly to the region being a much more disparate market. The only change in that, following the industry shift and MiFID II would be in who produces that research, and how much it costs.

Asia typically follows trends that originate in the West, so while the idea of unbundling is still relatively new to many in the region, firms are starting to see the benefit of more granular and detailed reports and the value they can get from these, even if they are not directly impacted by the onslaught of new rules. 

Impact on Asia

Besides research, there are several ways that the trading activities of firms in Asia could be affected by MiFID II, classified loosely into three categories, some regulatory lawyers say. First, there are the Asian branches of global banks; then there are separate legal entities that might sit under a European group; and last but not least, there are local banks, which might not have any dealings with European counterparties. 

ASIFMA’s MiFID II Working Group has focused on including pre- and post-trade transparency across all products trading on European trading venues, unbundling of research, legal entity identifiers, and instruments that are listed or traded on venues in both Europe and Asia. 

Vijay Chander, executive director for fixed income at ASIFMA, says a number of banks and other association members have engaged a mix of law firms, specialized service providers, consultants, and other external resources to advise on specific issues and to assist in the compliance process, while some members may not be subject to the rules, depending on the liquidity threshold of the traded instrument.

“It is worth noting that some of the impacts might well be de minimis. To quote just one example, a number of the Asian fixed-income instruments may not meet the liquidity and other thresholds to qualify for the pre-trade transparency requirements under MIFID II. If that is the case, and we can demonstrate to ESMA and the other relevant regulators that the bulk of Asian fixed-income instruments may not meet the various thresholds, our member institutions can request exemptions from the pre-trade transparency requirements,” Chander says.

Jason Valoti, partner at law firm Simmons & Simmons JWS, says the sell side—banks being the providers of financial services in this context—has to identify the way it provides services, when thinking about MiFID II and its impact in Asia.

Here, the key issues are the corporate structure of the bank and its geographic locations. “If you have a branch of a European incorporated bank in Asia, it would be a MiFID firm and have MiFID II policies, and that branch—by its nature of being a branch of a MiFID firm—would effectively be bound by those policies even if it was targeting only Asian clients, because the services are being provided by a European entity,” Valoti says.

But Asian entities, such as a separate legal company incorporated in Hong Kong, for example, would not be a MiFID II firm and therefore could operate its own non-MiFID II policies when targeting Asian clients as long as the services provided do not have a European connection. And if an Asia-incorporated entity dealing with Asian clients in Hong Kong wants to access transactions in Singapore-listed shares through some form of equity trading solution, it is a purely Asia-focused structure, and there is no nexus with Europe. 

But if that same entity was offering a client access to equities, bonds, derivatives, or structured products traded on an EU-regulated market or other markets recognized under MiFID II as an organized trading facility (OTF) or multilateral trading facility (MTF) in the EU, then the firm may well be subject to pre-trade and post-trade disclosure requirements, Valoti says. 

“And it would be caught if it was accessing the European market directly throughout its agreements with the exchange, or if it was accessing it through an intermediary. Basically, the end investor or the Asian client would be part of that information-sharing chain. For global banks—particularly those with operating in branches in Asia—we are seeing that they are being brought within a centrally managed compliance and oversight regime that the bank is implementing in its appropriate European head office,” he says.

Consistency Is Key

Valoti states that there has not been a consistent approach in Asia among regulators, as regulators in Singapore, Hong Kong, Japan and Australia are all in different stages. For an area like transparency, consistency is key to ensuring a truly transparent market in a particular asset class. For that to happen, formal legislation is needed. 

“It’s not up to individual institutions to second-guess what sort of transparency is appropriate. It’s very much ‘watch this space.’ My view is that the likelihood is that we will see—because of the size of the market in Europe, which is multiples of that in Asia—particularly for the large brokerages, a one-size-fits-all application, but this will happen over a period of time,” he says.