Bonfire of red tape

It’s time to repeal Brussels’ rules and allow the London Stock Exchange to flourish

It would make coverage of companies more honest. It would improve transparency. And investors would have more protection from some of the unscrupulous hucksters who often make a more than handsome living on the stock exchange. The EU’S 2018 reforms of the financial markets – known by the not very catchy name of MIFID II – were some of the most far-reaching ever conceived. And yet like so much Brussels regulation, it had a problem. The actual outcome turned out to be precisely the opposite of what was intended.

One of the big reforms was to prevent brokers bundling up analyst research in general service. Instead, it had to be charged for separately. In theory that was meant to make it more straightforward and to stop analysts pumping up shares on behalf of the bank they worked for. Instead, all it has done is reduce the amount of research available. And less coverage has meant fewer investors and lower equity prices. It has turned into a perfect illustration of so much Brussels rule-making: over-complicated and counterproductive. And the best thing the UK could do, now that we are out of the EU, is sweep those regulations aside and let the markets flourish again.

The old system of analysts covering companies was, of course, far from perfect. Teams of well-informed researchers would write up endless reports on a business, dissecting its finances and balance sheet, and rating it as either a buy, a sell, or a hold. A few – let’s be honest – would sometimes nudge a journalist towards a story over lunch, especially if it suited their interests. The expensively produced research was then distributed to professional investors for free and in return they expected some trades. In truth, there were plenty of conflicts of interest. Because analysts were paid by the bank or brokers, they were more interested in churning trades than absolute truth. And they tended to be way too optimistic. Company bosses didn’t usually feel like steering much business towards a bank that had just slapped a “sell” rating on their shares.

From 2018 onwards, the EU’S reforms swept aside that system. In the jargon, research had to be “unbundled”. In practice that meant investors had to pay for it. Sure, you can see why that might work better. The research would be objective, unbiased, and of higher-quality, and that would lead in turn to better investment decisions. Sounds good. Well, in theory. In practice it hasn’t quite worked out like that. A pair of recent academic papers in the last few weeks have confirmed what many already suspected from personal experience. Analyst coverage of individual companies has fallen dramatically. On many, there is virtually no coverage at all.

A study by Mark Lang, Jedson Pinto and Edward Sul argues that “the requirements of MIFID II were associated with a reduction in analyst following for European firms relative to US firms, with decreases in coverage greatest for firms that were larger, older and less volatile”. Another paper, by Giulio Anselmi and Giovanni Petrella, argues “that the payment of an explicit price for research is associated with a reduction in analyst coverage in the EU. Unexpectedly, the reduction is stronger for large-cap stocks.” True, analyst research has been declining in the US as well, largely as a result of passive investing (tracker funds don’t bother with research, because they just buy whatever is in the index). But not by nearly so much as it has done in Europe.

The result? There is also far less investment. Understandably, people don’t want to invest in companies that they don’t know much about. European stock markets are less valuable, there are fewer new listings and it has turned into a harder environment for companies to raise capital. We can see that in the figures. Over the last five years, the S&P 500 has outperformed the Eurostoxx 50, growing more than twice as fast..

At the same time, the number of companies listed across Europe has fallen from 7,392 in 2010 to 6,538 by the end of 2020. Sure, in some ways Europe’s stock markets are safer. There is less chance of a naive investor being talked into a stock five minutes before the whole business goes pop, and it is a lot less likely that you will see dozens of wildly positive brokers’ notes on an upcoming IPO, or a big merger, where the same bank happens to be an adviser. The trouble is, it is the safety of the graveyard. There is less risk because there is not much going on. Add it all up, and it is hard to see how anyone comes out ahead from that.

In many ways MIFID II is very typical of so much EU regulation. It is well intentioned, and might play well with some of the wonks at a few think tanks, but once it is let loose into the real world, it very quickly becomes over-complicated and counterproductive (its new carbon border tax, designed to control greenhouse gasses, has exactly the same faults to the power of 10).

Now that we are out of the EU, and with no realistic prospect of the UK ever being granted access to the single market in financial services, the best move we could make would be to repeal all of it in one clean sweep. We should let the banks and brokers hire analysts again, write what they like about companies, and sell that research any way they want to. Some of it might be a tad over-enthusiastic, and some of the lunches a little longer than is good for anyone’s health. And savvy investors will have to remember to take all those notes with a pinch of salt, and keep in mind who is paying for them.

But overall, the markets will be a lot more lively, information and ideas will start to flow once more, and the stock exchange will start to flourish – and at least one European bourse will have a chance of catching up with the US.

‘Now that we are out of the EU, the best move we could make would be to repeal all of it in one clean sweep’