New research from the University of Bath shows the European Union’s MiFID II financial market reforms inadvertently reduced research activity and adversely affected liquidity in London’s main stock market but that the impact on London’s less regulated Alternative Investment Market was mitigated by its special adviser rules.

The EU’s Markets in Financial Instruments Directive II (MiFID II) from 2018 aimed to improve transparency around research costs, which were previously bundled into brokers’ overall fees to clients. The legislation demanded the fees be ‘unbundled’ to make the hidden costs more explicit to investors and also to cut down the overproduction of seemingly ‘free’ research. But the new rules have proven controversial and EU and UK legislators are reviewing the legislation.

“Our research supports a growing understanding in the UK and EU of the unintended consequences of MiFID II and its negative impact on stock market liquidity,” said Dr Ru Xie of the University of Bath’s School of Management, co-author of the study ‘Research unbundling and market liquidity: Evidence from MiFID II’.

“MiFID II was a laudable attempt at improving transparency for clients, who could now see what research they were paying for and its cost alongside the regular bills for trading stocks and shares. But many brokers, under fierce competition with each other to attract clients, were forced to absorb those costs, meaning that they reduced the amount of market research they provided to clients – the UK’s Financial Conduct Authority estimated research budgets were cut by 20-30% since MiFID II,” she said.

Dr Xie said an estimated 12 percent drop in analyst coverage led to a significant deterioration in market liquidity in the highly regulated London Stock Exchange’s ‘Main Market’, where most equity, debt and securities are traded.

The average number of analysts providing research overage fell to 8.0 from 9.1 in the research period, which covers 2015 to 2020, three years before and after MiFID II was introduced. Surveys showed the coverage of small-and-medium-sized companies was particularly affected.

However, London’s more lightly regulated Alternative Investment Market saw research coverage increase over the same period by 6.3%, albeit from a much smaller level of around 1.5 analysts per company, and liquidity improve. The study also showed the quality of research forecasts, which improved marginally for the Main Market, improved significantly for AIM companies after MiFiD II.

“The reasons for this are twofold: as the demand for research for large companies fell, there was a flow of analysts to the less-populated market. However, the more significant factor may be a special feature of the Alternative Investment Market, which requires companies to retain a ‘nominated adviser’, known as a NOMAD,” Dr Xie said.

Dr Xie said the key factor was that NOMADs often had teams which produced research on their associated AIM company and that the quality of research benefited from the close relationship with the firm.

“When this research is issued it improves the AIM company’s market liquidity. We therefore suggest that NOMAD requirement may have mitigated the adverse affect of MiFID II that we identify in London’s Main Market, particularly for SMEs who are not required to have a nominated adviser if they are listed there,” she added.

Dr Xie said the study’s findings supported plans by UK regulators to introduce new research unbundling exemptions for SMEs.

"Our findings are relevant to the ongoing debate in many countries about the merits or otherwise of mandating unbundling rules. MiFID II's unbundling had the objective of clarifying financial transparency, but it may have inadvertently obscured the information pathways it sought to brighten,” co-author Professor Newton concluded.

The research team comprises Dr Ru Xie, Professor David Newton, Anqi Fu from the University of Bath, and Tim Jenkinson, Professor of Finance at the Saïd Business School, University of Oxford.

The research paper has been published in the European Financial Management Journal.