To make sound decisions, investors need information on markets – so analyst research is crucial.

This research has traditionally been produced as part of a bundle of services provided by sell-side brokers, with the costs passed on to investors. However, with limited transparency, there's a risk that brokerage firms could produce excessive amounts of this 'free' research, thereby driving up their costs unnecessarily.

In a bid to counter this, the European Union introduced the Markets in Financial Instruments Directive II (MiFID II) in 2018. This legislation was intended to increase transparency around the pricing of brokers’ services, impelling analysts to charge separately for research and trading.

However, as academics from our Accounting, Finance and Law division have revealed, its effects have unexpectedly backfired. In fact, the UK’s Financial Conduct Authority estimates that research budgets were cut by 20-30% as a result.

Dr Ru Xie explains:

“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 themselves, meaning that they reduced the amount of market research they provided to clients.”

Ru, along with Professor David Newton, Dr Anqi Fu and academics from the Saïd Business School, University of Oxford, examined data from the London Stock Exchange (LSE) spanning from 2015 to 2020 – three years either side of the implementation of MiFID II.

The team compared the market reactions of firms listed on the LSE’s Main Market with those on the less regulated Alternative Investment Market (AIM) – essentially contrasting the impact of the legislation on larger companies with the impact on small and medium-sized enterprises (SMEs).

They found that the Main Market experienced an estimated 12% drop in analyst coverage, which negatively affected market liquidity: the average number of analysts providing research to each firm fell from 9.1 to 8 over the period studied. However, research coverage for the AIM did not experience such a drop.

Ru explains:

“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’.”

These advisors, known as NOMADs, are corporate advisors that can provide research coverage as well as acting as brokers. Thanks to close relationships between NOMADs and the firms they are associated with, information sharing channels are stronger and the overall quality of research is better. This appears to have cushioned companies listed on the AIM against the adverse effects of MiFID II that were suffered by those on the Main Market.

David adds:

“MiFID II’s unbundling had the objective of clarifying financial transparency, but it may have inadvertently obscured the information pathways it sought to brighten."

Ru concludes:

“Our research supports a growing understanding in the UK and the European Union of the unintended consequences of MiFID II and its negative impact on stock market liquidity".