Tweaking MiFID II post-Brexit

Today signals the deadline for MiFID II compliance, new regulation that has been causing a sense of disquiet in some areas of the City, especially amongst advisers to and investors in smaller companies below the FTSE 250. A question worth asking is will Brexit allow some of the anticipated consequences of MiFID II to be addressed?

MiFID II covers numerous uncontroversial areas. But one stands out. Company research. From today unbundling means research will be priced separately from execution, putting pressure on fund managers to justify their research spend.

While this is unlikely to affect large companies, for the myriad of smaller companies the risk is that fund managers don’t really want to pay for research in hundreds of securities that they may never buy. Some fear this will make it even harder for smaller companies to get attention from investors.

One of the best-known figures in the small companies’ market is Katie Potts, who founded and runs the Herald Investment Trust. In its latest annual report, its Chairman said: “…the regulatory shock of the impending introduction of MiFID 2 has led to dire illiquidity, and commensurately wide discounts for smaller company trusts in general.”

This is more than an idiosyncratic issue for a minority of investors. If the smaller companies market dries up, it is hard to see how we can enhance UK productivity and invest in the innovation, entrepreneurship and new ideas of the future.

The domino effect of reduced research for small caps is potentially serious. With less research there is less liquidity. With less liquidity the attractiveness of a growth business looking to launch an initial public offering (IPO) disappears. In effect, a go-to source of funding for growing British businesses is removed. The result? Companies could turn to the debt markets or even a listing in the US to raise money. Some just may not bother to grow at all.

In the short term, while the UK is still a member of the EU or “in transition” until 2021, Brexit would not make any difference to the implementation of MiFID II. Large international firms are not going to countenance any move that will hinder their trading with the EU and nor should they.

However, after that, things may change. One of the most creative legal thinkers about Brexit is Barnabas Reynolds, a partner at Shearman & Sterling and was a contributor to Prosperity UK, a politically independent platform bringing together business leaders, academics and policy-makers to look constructively at a future outside the EU. He has written several papers on the subject and says that the UK should opt for an “equivalence regime” with the EU. This is the same status as countries like the US, Switzerland and Japan, and allows access to markets if regulations are broadly aligned.

The key thing about equivalence is it does not mean “identical”. It therefore allows some flexibility to change regulations which relate to domestic activity. Depending on how the trade negotiations go, and whether an equivalence regime is agreed or something more prescriptive, MiFID II could indeed be tweaked.

We will have to see how the deal comes out in the end.

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