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MiFID II: Unbundling lessons from other industries

Bryan Adare, Principle Consultant, Brickendon

In order to fully understand the true implications and consequences of the Markets in Financial Instruments Directive (MiFID II), the financial services (FS) sector should look to other areas to learn how best to anticipate looming change and prepare in advance.

The complex framework is due to come into effect in 2018 and will likely have far-reaching and wide-ranging consequences throughout the financial world. Amid ongoing uncertainties and concerns around the true scale of the challenges posed by implementation and compliance, drawing parallels with other sectors and industries is a useful and instructive tool for gaining valuable insights ahead of the looming deadline.

With this in mind, we wanted to look towards less typical sources of inspiration for the FS sector as it prepares for yet another regulatory overhaul in the form of MiFID II.

Taking to the skies
Earlier this year, British Airways removed complimentary food and drinks from their short-haul European flights. A long-time coming as part of many changes to reduce costs, CEO Alex Cruz decided that removing the complementary service in an environment increasingly dominated by low-cost competitors was the best way to improve profitability and maintain price competitiveness.

The changes were not taken well by BA customers, with both leisure holidaymakers and corporate frequent-fliers up in arms about the loss of the previously complementary service. Airline pass engundling previously free research services.

Changes like this are part of a larger trend in the airline industers are however not the only ones subject to so-called unbundling. As part of the new MIFID II legislation, banks are on the verge of unbry’s unbundling. Within the industry, it has been pioneered by the low-cost segment as a way to create the lowest ticket price for consumers who just want to get to their destination without any frills. Those who want additional services can pay for what they use. Reducing included services is one of the pillars of the low-cost model, and legacy carriers have been struggling to determine how to price competitively, yet continue to offer the level of service their customers expect. Initially it was led by the removal of simple items like checked-in baggage and exit-row seat selection, but has now evolved to cover almost any service traditionally included in the price of admission, from the on-board food and drink service and seat selection in any part of the cabin; to boarding order and number of carry-on bags.

Naturally, the changes have had an impact on ticket pricing across the board, with legacy carriers reducing their core route prices year-over-year to compete in a market which is generally driven by the lowest advertised price. While flyers are shy to praise these price reductions, they are quick to complain about the removal of services. From a frequent-flyer perspective the impact can be great: they are losing their Thursday night commuter drink and are unable to charge purchases back to corporate policies. For leisure travellers, the degradation in service quality from the expectations set by BA following years of high-quality on-board service, could be one of the final nails in the coffin that drives holiday makers to cheaper low-cost carriers.

Comparisonswith the FS sector
Similarly, the investment and asset management industry is also dealing with unbundling, though this time driven by a completely different force, namely the regulatory requirements of MiFID II. As part of the regulations that take full effect from 3 January 2018, portfolio managers and buy-side professionals are barred from accepting free research insights as this could be viewed as an ‘inducement’ under the terms of the MiFID II regulations. The new legislation imposes stringent conditions on clients’ payments for research and requires the use of a dedicated Research Payment Account (RPA) to allow for a buy-side client to pre-select the quantity of research and focus the coverage as they find applicable.

The implementation of these new rules has not been simple for anyone, with major initiatives being taken to ensure the changes are implemented from all perspectives. Sell-side firms have been sluggish to implement the necessary changes, as they also seek to implement numerous other global regulations which have come into force in the last few years. Going forward, buy-side firms are likely to be reluctant to start paying for a service which used to be complementary.

Fundamentally, sell-side institutions work as a gift economy. They provide research, introductions to CEOs, trade ideas and informal advice in the hope that buy-side institutions will later pay them to execute trades or structure deals. This is not to say that research is entirely free, but the payment mechanism is entirely at the buyer’s discretion. Funds are allocated to research and the buyer chooses after the event how to allocate those funds amongst the organisations that provided the research content. In other words, banks provide the advice and are only paid if the buyer believes it was worthwhile.

MIFID II rules are about to tear up this relationship. Not only will buyers pay in advance for advice without knowing how to value it, but the advice will need to be fully costed and not provided at its current large discount.

Looking to the future – potential lessons and next steps
There are some professionals who wonder what effect this will have on the core relationship between the buy-side and sell-side, and whether there will be a place for research-oriented institutions going forward. Others are concerned that there will be less incentive to cover smaller entities from a research perspective, which could lead to a significant reduction in liquidity for smaller and less-prestigious listed entities.

The low-cost airline market uses product unbundling as a way of gaining price advantage in a heavily commoditised market by tapping no-frills customers to fill seats and grow volume. There are some industry insiders who suspect that the financial world could leverage this model. The opportunity is now opening for new entrants who can provide execution services at rock-bottom prices with no-frills, and for research-only firms who can provide top-ranked research at lower cost, without the infrastructure and overhead of execution.

Time will tell for airlines how well unbundling works, with the low-cost model sure to continue for those already in the space. Some legacy US carriers have already back-tracked on their cuts to food and beverage offerings, and British Airways has recently re-introduced complementary seat selection for status holders in their Executive Club even on basic fares. For the investment industry, it appears that the regulations, and costs involved in meeting those, will ensure the new status quo remains for the time being.

As for the low-cost airline model, both corporate road-warriors and leisure holiday makers seem to be continuing to flirt with low-cost carriers. However, many customers now buy their meals before boarding the plane, believing they can get a better price or better quality product. Whether the buy-side implement a similar strategy of shopping around and if they do, what will this do to the trade execution costs that the sell-side is able to charge, remains to be seen. Whatever the outcome, it is definitely an area to watch and one where many lessons are still to be learnt.

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