(Bloomberg View) -- Happy MiFID II Day.
The European Commission's Markets in Financial Instruments Directive II went into effect today, with a bunch of new rules including limits on dark pools, increased pre- and post-trade price transparency and changes to fund marketing and research costs. So far so quiet -- "trading volumes slumped ahead of the changes, according to two brokers with knowledge of the matter, with client business at one major brokerage in Europe almost non-existent as the rules were poised to take effect Wednesday" -- though to be fair it is the first week of January.
One MiFID II change that we have discussed a lot involves investment-bank research pricing: Investment funds will no longer be allowed to get research for "free" and effectively pay for it with brokerage commissions (which are passed on to their investors as trading costs); instead, the fund firms will have to pay for research directly and either explicitly charge investors or eat the cost themselves. Most fund firms seem to be choosing the latter option, because making investors pay for research is administratively difficult and sort of chintzy. That probably means that overall research budgets will shrink and independent research firms will have a tough go of it, as Bloomberg Gadfly's Chris Hughes points out.
One problem with making banks charge for research is: What is research? We talk from time to time about "desk commentary," which is a thing where someone at a bank emails a client with a trade idea, but the person at the bank is not a "research analyst," and the trade idea is not a "research report." If you are in the business of regulating research -- as U.S. regulators long have been, and as European regulators now are -- then you have to distinguish a salesperson selling a trade idea from a research analyst selling research. That is not necessarily easy, as the ultimate goal of both salespeople's emails and research analysts' reports is, after all, to get clients to do trades. And in early going MiFID's distinction might be crude:
Solicitations from traders looking to pick up business from the buy side will drop significantly as the regulations stipulate that all research must be paid for. Money managers are even taking steps to block emails from those firms that have been dropped from their broker lists.
It's going to be weird if the only emails that money managers are allowed to receive are the ones that they pay for.
A MiFID II change that we have discussed less often involves the limitations on dark pools. The first objective of the directive is "ensuring financial products are traded on regulated venues," getting rid of dark pools and driving trading onto public exchanges. But the regulators made some odd choices, disfavoring dark pools but creating an exception for "systematic internalizers." If a bank (or high-frequency trading firm) runs a dark pool where its clients can trade with each other, that's bad, but if it runs a dark pool where its clients can trade only with the bank (or high-frequency trading firm), that's fine. There is a logic to that -- trading directly with clients is a traditional dealer function of banks -- but if it leads to every bank setting up its own systematic internalizer and trading with clients in a walled garden, then that will be an odd way of "ensuring financial products are traded on regulated venues."
Another MiFID II change is that investment funds will have to do a better job of disclosing their fees so that investors can comparison shop. Unfortunately when regulation mandates better disclosure, the result is often more, but worse disclosure:
Investors “will face a patchwork of contradictory information in 2018,” said Thomas Richter, chief executive officer of the German investment funds association BVI. “This will confuse consumers rather than making things clearer.”
For the first time, fund managers must disclose a breakdown of their fees to banks, insurers and other distributors. Investors will receive as many as four different documents for the same fund, depending on whether it comes from an asset manager, a bank, an insurer or a German pension product known as Riester, according to BVI. The way costs are disclosed is up to the distributors and the methodologies and estimates used to calculate transaction costs vary between fund managers.
Elsewhere in MiFID II news, "Ice Futures Europe and the London Metal Exchange were given an extra 30 months to comply with rules related to clearing on the very day they were due to come into force," and Eurex got a similar delay in Germany. And: "Who Wins, Who Loses From MiFID II Shakeup?" And: "What Investors Need to Know About Europe's Big New Mifid Rules."
Free underwriting!
Investment banking, I often like to say, operates as a sort of gift economy in which banks do lots of free favors for companies in the hopes of getting lucrative paying work from those companies later on. But this is a little different from the gift economies that anthropologists describe in traditional societies. In traditional gift economies, the gifts that I give you today and the gifts that you give me tomorrow tend to be of a similar category: I give you luxurious cloth or a lavish dinner today, you give me back fancy armor or an even-more-lavish dinner tomorrow.
In the investment-banking gift economy, though, the gift that the banks give to the companies is free work. (Also sports tickets and steak dinners and jobs for the companies' executives' kids, but principally free work.) And the gift that the companies give back to the banks is the opportunity to do more work. In both cases, the transaction looks like the bank doing work for the company. It's just that when the bank is buttering up the company, it undercharges for the work; when the company is rewarding the bank for its loyalty, it overpays for the work.
So how do you decide what work is free and what work is overpaid? There are some intuitive dividing lines: Banks do lots of free work analyzing potential mergers, and then are lavishly compensated for executing actual mergers, and it would obviously be strange to do the reverse. Charging for analysis of a merger that goes nowhere leaves a bad taste in everyone's mouth, but if a company is merging out of existence, or spending billions of dollars buying another company, a few tens of millions of dollars of bankers' fees seems trivial.
But a lot of the divisions are arbitrary and shifting. (Part of the point of MiFID II, after all, is to shift the gift economy so that research is no longer a free gift for institutional clients.) When I was a banker, for instance, a perfectly normal approach would be to do lots of financial analysis for a company in the hopes that it would one day mandate you on a bond offering. Bond offerings can be easy and lucrative, and so are a sensible reward for companies to give to banks who have demonstrated their loyalty through free work. But there is nothing necessary in that, and in Asia the bond offerings themselves seem to have become the free work:
Barclays PLC and Standard Chartered PLC were among seven banks that recently helped sell a total of $1.3 billion in dollar-denominated bonds from three state-owned Indian companies, effectively providing their services free of charge. The three Indian companies paid a dollar in underwriting fees to each bank that handled the sales, according to company representatives and people familiar with the matter.
A similar trend is emerging among banks underwriting some Chinese bond offerings, bankers say, particularly in the case of state-owned corporations that have large pools of underwriters to choose from and tend to be stingier with fees.
Banks that agree to arrange bond offerings for ultralow fees are generally hoping to build relationships with corporate clients for future deals. They are also hoping to generate revenue from related businesses, such as fees for setting up foreign-currency swaps or on bond-trading commissions.
Instead of free analysis for a lucrative bond offering, the exchange now is a free bond offering for a lucrative swaps trade. The trick, if you are a penny-pinching client, is to roll this forward indefinitely. Banks are always hoping to build relationships with corporate clients for future deals, which means that if you ask nicely and persuasively enough you can get pretty much anything you want for free. They'll do your financial analysis for free in the hopes of getting your bond offering, they'll do your bond offering for free in the hopes of getting a swap trade, they'll do the swap trade at scratch in the hopes of getting a privatization mandate, they'll do the privatization for free in the hopes of getting a merger mandate, it can go on and on. This only works, though, if you are a big enough company that the banks can tell themselves that you'll one day give them a lucrative deal. If you're not big and rich, you'll have to pay for stuff. The free stuff is limited to the companies that don't need it. This gift economy, like many traditional gift economies, is limited to the elites.
State tax arbitrage!
Last month we talked about a paper by some tax lawyers looking for loopholes and glitches in the new tax plan. I described one glitch:
States should solicit charitable donations to pay for roads and schools, and make those donations fully creditable against state taxes. The rough idea is that if you have $50,000 of state tax liability, that is no longer deductible from your federal taxes -- but if you instead donate $50,000 to the state, that is deductible from your federal taxes as a charitable donation, and if the state reduces your taxes by the $50,000 donation then you come out ahead. This is the simplest and clearest of all regulatory arbitrages: Giving money to the state as taxes, and giving money to the state as a donation, are economically equivalent, but they will be treated differently by the federal tax code and so there will be incentives to shift from one to another.
The amazing news is that it might actually happen! Here are articles in the New York Times and the Mercury News about state lawmakers who are considering 100 percent tax credits for donations to the state: The donations would be deductible from federal taxes as charitable gifts, and would reduce state taxes dollar-for-dollar, making them effectively a more federal-tax-efficient way to pay your state taxes.
In one sense, I mean: obviously. If you can arrange your affairs in a tax-efficient way, it is downright negligent not to. If state leaders want to attract residents and companies, then making their state tax system as federal-tax-efficient as possible is a no-brainer way to do it: It costs the state nothing, and improves the residents' and companies' position. It's free money. (From the federal government.)
In another sense, though, it is odd. Of course taxes are a game to be optimized, and of course companies and individuals and tax lawyers -- the people who pay the taxes -- think of them that way. But usually legislators -- the people who write the tax rules -- don't think of them that way. They think of taxes as a moral obligation, a way to buy civilization; they profess outrage when people exploit loopholes to minimize their taxes. It's weird to see state legislators joining in the fun. But they have an excuse:
Companies, of course, have long sought to exploit loopholes in the tax code. Governments, as a rule, have not. State leaders, however, said Congress, in singling out certain states, had broken an implicit compact with the states.
That seems right but is troubling. If Congress treats the tax code as a weapon to be used against Democratic-leaning states, and if those states treat the tax code as a game to be optimized, then why should taxpayers treat the tax code as carrying any sort of moral obligation? Clearly the tax-writers don't.
Crypto.
The big news in bitcoin yesterday was that "Founders Fund, the venture-capital firm co-founded by Peter Thiel, has amassed hundreds of millions of dollars of the volatile cryptocurrency," though it started buying in 2012 and has actually spent "no more than $20 million" on bitcoins; the rest is market appreciation. Bitcoin is of course a bit of an odd investment for a venture-capital firm, which you would normally expect to invest in funding early-stage private businesses, not in buying currency or whatever bitcoin is:
By buying bitcoin outright, as opposed to backing other companies doing business in the space, Founders would seem to be breaking with its investing tradition, an investor said. But in communications with investors, Founders representatives have sought to cast the investment as a high-risk, high-reward wager similar to its other venture bets, the people familiar with the matter said.
What a weird thing to say! Roulette is high-risk, high-reward. What distinguishes venture capital is not that it is "high-risk, high-reward." It's that the rewards come from investing in early-stage private companies, and that the venture capitalists have expertise in evaluating private companies and their founders. Bitcoin isn't a company, and its founder is secret. And most people can't just buy shares in early-stage private companies. (Because they are private.) Venture-capital funds offer investors access to those companies, in exchange for large fees. But anyone can just buy bitcoin, or play roulette, directly. You don't need to pay venture-capital fees to have someone else buy bitcoin for you.
To be fair, while "let's just buy bitcoin" is not a particularly compelling intellectual thesis for an investment fund, it would have gotten killer returns over the past year. (Way better than the actual venture-capital version of that thesis: "The performance gap between bitcoin-related startups and bitcoin as a currency has been a sore point during partner meetings at some venture firms.") And while "bitcoin, but we'll keep 20 percent" is not a particularly compelling intellectual thesis for a cryptocurrency investment, it is better than most of the other cryptocurrency investment ideas I've seen recently. For instance here is Useless Ethereum Token, which is what it says on the tin, and which claims to have raised over a quarter-million dollars to buy its promoter a lot of flat-screen televisions. It bills itself as "the world's first 100% honest Ethereum ICO" insofar as it says up front that it will take your ether and give you nothing in return, but actually it's about the tenth initial coin offering that I've seen promising just that, and they all raise money. Founders Fund's approach -- it'll only keep some of the bitcoins it buys with your money -- is comparatively generous.
Elsewhere, U.S. congresspeople maybe don't have to disclose their cryptocurrency holdings? And: "North Korean Hackers Hijack Computers to Mine Cryptocurrencies." And: "Hooters Franchisee Surges 41% on Cryptocurrency Rewards Program."
Tech sex parties.
The telos of Silicon Valley is to (1) build electronic tools that will eliminate the need for human beings to work and (2) then replace human work with dumb pre-industrial magic rituals. In a science-fiction future where robots do all the jobs and satisfy your every need, what will you do all day? Well, maybe you'll get really into elaborate quests for water, why not.
That was in reference to Juicero founder Doug Evans, who spends his nights hunting for "raw water," but other tech moguls have other, more conventional notions of what to do with their free time. Here is Bloomberg's Emily Chang on the sex parties of the Silicon Valley elite, which have an extra poignancy because they are full of dorks:
Many of the A-listers in Silicon Valley have something unique in common: a lonely adolescence devoid of contact with the opposite sex. Married V.C. described his teenage life as years of playing computer games and not going on a date until he was 20 years old. Now, to his amazement, he finds himself in a circle of trusted and adventurous tech friends with the money and resources to explore their every desire. After years of restriction and longing, he is living a fantasy, and his wife is right there along with him.
Married V.C.'s story—that his current voraciousness is explained by his sexual deprivation in adolescence—is one I hear a lot in Silicon Valley. They are finally getting theirs.
I guess that explains the effort devoted to virtual reality too, but sure.
Things happen.
Dominion Energy to Buy Scana, Absorb Costs of Failed Nuclear Plant. France gears up for big privatisation drive. Wall Street's Venezuela Bet Rests in Hands of These Seven People. MoneyGram and Ant Financial Call Off Merger, Citing Regulatory Concerns. Wild Swings in Money-Market Rates Highlight Limits of Regulation. Spotify hit with $1.6 billion copyright lawsuit. First Comes the Bone-Rattling Cold, Then Comes the Snow Bomb. Watch a Man Play ‘Sandstorm' on a Potato.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.
For more columns from Bloomberg View, visit http://www.bloomberg.com/view.
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