Europe's Existential Threat to U.S. Capital Markets
Requiring seven years to draft and weighing in (currently) at 1.4 million paragraphs of rules and regulations, Europe’s new Markets in Financial Instruments Directive II will affect virtually every bank, mutual find, exchange, broker, pension fund, retail investor and high frequency trader that does business in Europe. In other words, almost every financial services company in the America. The European Union’s social engineers will try to regulate virtually every aspect of the financial markets, covering everything from maintaining taped conversations of securities orders to regulatory filings for transactions that can stretch to more than 65 separate fields.
Among the most controversial aspects of the law involves the unbundling of the costs of research from trading and “best execution.” At first glance, this seems a minor change and added layer of transparency that should be a welcome development for consumers of investment management services. Dive deeper into the implications of this change and it isn’t difficult to imagine the law as a major threat to America’s financial sovereignty. This has much to do with an already marked decline in the vibrancy of Uncle Sam’s public markets and secular decline in initial public offerings. Given the fact that the major stock indices are reaching all-time highs, it may be surprising to learn that the total number of public companies in the U.S. has declined by nearly 40% since 1997. This has been due in large part to the massive increase in costs associated with being a public company resulting from our own Sarbanes-Oxley law and the simultaneous growth in the private equity industry. This combination has greatly thinned the herd of companies wishing (or able) to go public and greatly limited the potential of the individual investor to benefit financially from the growth in the country’s most exciting and innovative common stocks.
MiFID II promises to create further disincentives for companies to list their stocks publicly by kicking an industry already down on its luck. Many small issuers are finding it almost impossible to find Wall Street research departments to cover their stocks and spread the gospel of their business prospects. Because institutional investors pay for their trades on a cents-per-share basis, the absence of stock splits and the current all-time high level of the average price of a stock has severely damaged the earnings of companies providing company specific research. Forcing investment managers to pay cash for research will place undue burdens on small asset managers and small sell-side research companies alike. Thousands of companies too small to be covered by large bulge bracket investment banks will lose any type of Wall Street sponsorship.
All this reminds one of Milton Friedman’s famous observation that big government “solutions” usually result in the perverse effect of benefitting big companies. Smaller companies without the financial resources to hire the consultants, lawyers, and lobbyists needed to carve out legal exceptions or bear the costs of such “solutions’ wind up as the biggest losers. Some large investment managers and brokers are already using the law to engage in business practices that could only be considered anticompetitive. Large bulge bracket firms in Europe have already offered to make a significant portion of their research publicly available for free. What logical explanation could there be for large companies incurring hundreds of millions of dollars in conduct investment research to suddenly decide to give it away? Large players on the buy side are also getting into the act by offering to pay for their research costs out of their own P&L rather than with commissions. Large investment firms can afford such piety while smaller investment managers are likely to find themselves unable to bear the costs of performing or buying high quality investment research. Many are likely to be so impaired as to either be forced to sell their assets to larger players or cease operations altogether.
Many proponents of the change think back to the bad old days when investment managers would use “soft dollars” to pay for business expenses, like office rents and lunch, that should have been borne by the firm’s owners rather than their clients. Such practices have long been prohibited although the SEC did grant a “safe harbor” for commissions to be used for research, recognizing it as an integral part of the investment process. For its part, the SEC has tried to address these potentially deleterious effects on America’s capital markets by issuing what they call Non-Action Exemptive Relief from the rule. The measure doesn’t go nearly far enough and will likely lead to MiFID becoming the global standard not because it is a better law but because all financial players will be more concerned with running afoul of regulators in Brussels than with acting as long-term fiduciaries for their clients. Long a source of pride for the U.S., the financial services industry has much more to lose here at home than on the Continent.