It’s been a week since the UK’s Investment Research Review was published – and since Chancellor Jeremy Hunt confirmed that the government and the FCA would be allowing the re-bundling of research. BEST EXECUTION sat down with review chair Rachel Kent of Hogan Lovells to lift the lid on the nuts and bolts of what really went into the review, what came out – and what to expect next…
Why now?
“The catalyst for the review was the government and indeed the industry’s concern over the operation of the UK capital markets as a whole – probably sharpened by the strong feeling that some UK-headquartered companies that could and should have listed in the UK have chosen to list elsewhere,” said Kent.
There have been general concerns around the UK’s capital markets efficiency for a while now, and these have spawned a number of different initiatives: including the UK Listings Review led by Lord Hill (published March 2021), the UK secondary Capital Raising Review led by Mark Austin [established December 2021], the LSEG taskforce established by Julia Hoggett in July 2022 and TheCityUK’s Capital Markets Group, co-chaired by Claire Suddens-Spiers. Along the same lines, one of the Edinburgh Reforms commitments made by the government last year was to look into the contribution that is being and could be made by investment research. Does investment research help with the capital markets ecosystem, and if it does, what are the issues preventing it from doing so?
“There was certainly a feeling that research is one of the components of the capital markets that is not be working as well as it could, and in order to oil the wheels, we needed a review of the whole process,” agreed Kent.
“Research is one of the components of the capital markets that is not be working as well as it could.”
Why Kent?
A senior partner in Hogan Lovells’ financial services regulatory team, Kent has extensive experience of leading investigations of this kind – not just as Kalifa vice-chair (policy and regulation), but also as chair of the International Regulatory Strategy Group (IRSG)’s Brexit Working Group on international access and competitiveness, the IRSG’s UK regulatory committee, the lead author on three of post-Brexit reports, and member of the City of London and Innovate Finance’s Fintech Strategy Board, CityUK’s Europe Market Advisory Group, HM Treasury’s Expert Trade Advisory Group, Advisor to the Independent Review of Ringfencing and the Financial Market’s Law Committee.
In other words, she knows what she’s doing. But that doesn’t mean she knew the outcome before she started.
“I was lucky to have had some experience of these things before, so I knew the ropes,” she explained to BEST EXECUTION. “But people did say to me ‘oh, well you obviously know in advance what you’re going to recommend’ – and actually, I didn’t. In fact, even if I’d had an inkling, that’s just not consistent with my approach: I wanted to find out what everyone else wanted first. What does it feel like, operating in that part of the ecosystem? Is it all working? Are there problems? As a professional services practitioner you are obviously one step removed from that reality, so it was very important to cast the engagement net as broadly as possible and speak to as many people as I could. That was the intention at the outset and happily, our initial call for evidence got a significant number of responses – which continued right up until literally the day before the report was published. People also contacted me directly, I had a significant number of one-on-one interviews – often more than one – so we had a huge degree of engagement and, frankly and more importantly, a huge degree of alignment.
“People did say to me ‘oh, well you obviously know in advance what you’re going to recommend’ – and actually, I didn’t.”
“By the end, we’d achieved a notable degree of agreement: both on the huge value of research, on what the problems are right now, and (to a certain extent), what the solutions should be. We kept our recommendations close to our chest because we didn’t want to delay the output (obviously, we’d had a substantial debate around the input), but all the feedback I’ve had since publication has been supportive of the recommendations.
Why rebundling?
“I think that by the end of the debate, everyone was aligned around the fact that change to the regulation was necessary, or at least helpful. The buy-side will tell you that a regulation that prohibits you from doing something unless you jump over costly compliance burdens is not a sensible regulation. Our recommendation was to facilitate optionality, not to mandate anything.
“The original point of unbundling was to bring transparency to the cost of research. It was not to take the cost of research from the end user and place it on the P&L of the buy-side. That was absolutely not the intention, which means that for the last five years we have very much been operating in the realm of unintended consequences. And it has had a huge impact. If the overwhelming weight of evidence is to be believed, then there is significantly less demand for research than there was previously. And no doubt there were some benefits in terms of extra care and attention towards monitoring those costs, so I think MiFID II did shine a light on some things and that was a good thing, I don’t think anyone would argue with that.
“But at the same time, is it sustainable for the buy-side to spend increasing amounts of money on this? And one of the unintended consequences has been increased costs for the buy-side. But it’s a much more complex story than that.
Why is change needed?
“We heard that the amount of money that has gone toward funding research has fallen significantly, which has had an effect on all the providers of that research. I don’t think we found a single person who could tell us that the standalone provision of investment research is a profitable activity anymore. The sell-side regard themselves as price-takers, so they get told the amount of money that will be spent on research. Even where coverage is strong, that remains an issue.
“But it means research, particularly around large caps (where research has now focused), has turned into a loss leader, and it has to be offset against other sources – for example, trading income. In the context of an independent research house it is difficult to compete – while in the smaller cap arena, trading volumes are much less significant so it is also harder to make an economic case for research.
“There is a ‘paucity’ of research at the mid and smaller range – and now, we’ve seen government proposals that aim to stimulate interest and demand in this exact space, particularly from pension schemes. This area is now seriously lacking research yet demand is going to potentially grow. It is in this area that, the new innovative intangibles businesses can be found like quantum computing, AI, the stuff that the UK is really good at. It’s self-evident that this is the area in which we now really need research.
Will the buy-side buy it?
“I think there is only really one area over which there remains a question, and that is, whether people will take up the flexibility that unbundling will hopefully deliver to the market. Changing the regulation itself is obviously helpful, and a necessary step, but it doesn’t itself drive the cultural and behavioural change that is needed to change the market.
“The regulation will also be changed to facilitate bundled charging – in fact, to facilitate charging via whatever mechanism you choose. That seems unarguable to me. How can people say that they don’t want flexibility? But to make that work, the buy-side have to have implemented appropriate arrangements with their clients, in the context of the future environment, about what is an equitable allocation of those research costs between buyer and clients. That requires a change in attitude on the part of the buy-side and an agreement to that on the part of their clients, so it will be a journey – it won’t happen overnight.
Why the new research platform?
“If the lack of funding doesn’t resolve itself, then the creation of a research platform with multiple funding options (yet to be determined by the government) will achieve the same thing. It will inject funding into the system where there are gaps. Whether the issuer pays, or the exchange pays, or we have some kind of market levy tied to participation, i.e. one that is tied to transactions (with a possible stamp duty rebate) remains to be seen. That mechanism would certainly solve the problem, and provide the funding that is so badly needed.
“These changes are designed to support and stimulate existing research providers. There are two key issues here that needed to be solved. The first is more demand – you can have all the greatest research in the world but it doesn’t matter if no one wants to buy the equity. That is where the government’s pension reforms come in.
Read our analysis of Jeremy Hunt’s Mansion House speech (including pension reform details and small cap analysis) here.
“But that still doesn’t solve the research problem so the second issue remains funding, which is absolutely crucial. Whether you’re talking about independent or bulge bracket research teams, they’re all incredibly keen to sink their teeth into these new areas and provide quality research that will support these new businesses and ultimately support IPOs in the UK – the energy is there, the commitment, the will, the skills and the experience are all there – it’s just the funding that’s the problem. That’s why an appropriately funded research platform is key.
What about retail?
“The next issue is all about making investment research more widely available to the retail investor. We heard that the liquidity that results from retail trading is disproportionately higher in the smaller and mid cap companies than it is in the large cap companies. So it’s important to also stimulate and support retail demand. There are moves afoot to encourage retail investment, particularly in IPOs, including rule changes (not part of the Investment Research Review) designed to support that. But it seems ridiculous to me that when you are encouraging the retail market to take advantage of IPOs, they are permitted to do that under the regulations permitted to receive the prospectus… but they are not permitted to see the research that scrutinises that prospectus. That is clear information asymmetry compared to institutional investors.
“Whether the solution to that is making institutional research more widely available, or whether that is taking a hard look at the regulations applying to retail research to encourage tailored research for the retail market, I think we urgently need to take a look at what can best be done. That’s what the FCA needs to look at now. The more broadly you shine a light on these opportunities, the more likely there will be investor interest, which will create liquidity, which will support this natural cycle.
Why a code of conduct?
“I think that realistically, we hope to see increased demand for research. Yet the number of analysts has fallen, and there’s an acknowledged problem around ‘juniorisation’. So we need to support all the component parts of the research industry to solve this problem – whether that is sell-side, buy-side, brokerage firms, or independent/sponsored researchers.
“If you speak to many smaller cap issuers, for example, they say that their only way of accessing research right now is to pay for it themselves. That’s the sponsored research market, and there’s no denying that there have been some concerns in this area. I think we need a code of conduct to avoid certain issues like, for example, conflicts of interest in the context of researchers being paid in shares of the company they are researching. They may be tempted to tell a more positive story. Market players wanted a code of conduct setting out best practice to deal with these perceptions.
“The French have gone down the code of conduct route – it is something that exists in many other jurisdictions, and it’s not a new idea, internationally-speaking.
What about the original concerns around inducements, etc?
“There were very good reasons why the unbundling was brought in with MiFID II back in 2018, and those concerns do still exist. But I think that they are addressable without these unintended consequences. As we know, the US has not moved on from unbundling – so our current regime is already extremely challenging, from an international perspective, because we risk not being able to pay for US research. But the other key element is that the EU is now also looking at bundling, and a united approach could be a game-changer.
“I’m not trying to undermine the concerns that led to unbundling. But I think that the path we now have to navigate is to allow a bundled approach, and then apply a regulatory regime that appropriately deals with these issues, but doesn’t stifle their use completely. A lot of areas in financial regulation rely on a principles-based approach, to facilitate protection without detailed and prescriptive rules, and I don’t think the field of research needs to be any different.”
“I’m not trying to undermine the concerns that led to unbundling. But I think that the path we now have to navigate is to allow a bundled approach.”
What next?
“One of my recommendations is to introduce a bespoke regulatory regime, which I do think is necessary. What is notable about many of the provisions in the rules that apply to investment research is how complex it all is. Where are the perimeters in terms of research? What is a recommendation? It’s very, very hard to navigate, and I say that as an experienced financial services regulatory lawyer.
“But I think the complexities are accidental, and they are unnecessary. This should not be a complex thing to regulate. The complexity comes from trying to combine a regime that relates to the whole broad slate of investment advice with the provision of wholesale investment research. They are two different things, but they’ve been shoehorned into the same regime. I am suggesting that we take research out of that, and have a self-standing regime that focuses only on those issues that affect this specific part of the market, making it much simpler and easier to navigate.
“If we’re serious about supporting the capital markets in the UK, and we want to make the UK a centre of excellence for the provision of research – not just for UK companies but for new and innovative sectors globally – then why apply all sorts of complex and difficult rules that put off the very people that we’re trying to attract?
“The complexities are accidental, and they are unnecessary. This should not be a complex thing to regulate.”
“All we are doing is recommending that it be rationalised. This is not about a race to the bottom. This is not about taking away regulation. It’s just about making it fit for the particular purpose and easier to navigate.”
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