James Penn puts the spotlight on controversial new EU legislation inthis, his fortnightly column for Business News.

MIFID II - innocuous-sounding, but potentially troublesome.

Banks, brokers, and fund managers are currently struggling with this EU legislation (’Markets in Financial Instruments Directive’ to give its full title) , which comes into effect for European financial institutions from January 3rd next year.

Its implications are manifold, covering ’dark pools’ through to ’algo trading’, but the general import is to increase transparency and possibly reduce costs for clients. It is also causing an uplift in regulatory burden, and an increase in costs, for the providers of investment services.

Brokers and investment managers will in future need to have individual identification numbers (called LEIs) for each client. Each trade will need to be documented, down to ultimate beneficial owners and the precise time of execution.

Many dealers, brokers, and investment firms are having to employ third party providers to document the information, given the vastness of the task involved.

Transactions on 15 million financial instruments, traded on 300 exchanges, will be monitored in future.

While not overtly aimed at combatting tax evasion or insider dealing, it will surely have implications in this direction, given the huge increase in data that will be available for scrutiny.

Many assets that currently trade Over The Counter will in future be traded on an exchange, mirroring what the US introduced in its own Dodd Frank laws in 2010. Automated trading will be much more heavily regulated, with ’algorithms’ - used in automated trading - in future needing to be registered and tested.

The ramifications are vast, but this column is going to focus specifically on one aspect - the implications for investment management groups of the prohibition of ’bundled’ research.

For many years, the asset management industry has worked on the basis that asset managers buy and sell stocks through brokers, with the investment research provided ’for free’, wrapped up in the cost of the dealing commissions.

The EU argues that this could be seen as acting as an incentive to direct trades to certain brokers, which might then appear to contravene the requirement to give ’Best Execution’ to clients.

Given ’bundling’ has become so prevalent in many other areas of the economy, particularly telecoms and entertainment provision, it seems odd to be focusing an attack here.

In future, asset managers will have to pay for research separately. Dealing commissions for clients may fall as a result, but are already low (having fallen to an average of 0.15% from 1.5% fixed commissions pre-Big Bang).

Asset managers will need to decide how to pay for the research in future - whether to pay for it themselves, or to pass on the burden to clients as a designated cost.

If asset managers absorb the costs themselves, this will have an impact on their own ’bottom line’. Asset managers could alternately choose to ignore external, or third party research, and carry out their research through internal managers. But this does reduce the variety of opinion, and can encourage ’group think’. It also favours the biggest asset managers, who already have large numbers of internal analysts. But even the biggest of these may not have the industry insight that a sector specialist at a sell side investment bank may have.

Of the large investment firms, the majority are choosing to absorb the costs themselves. There is an element of herd mentality in this - when one prominent manager decides to go this way, others may feel compelled to follow, as it might otherwise give the first manager a competitive advantage.

Thus, recently we saw Schroders and Janus Henderson opting to absorb costs, having previously aimed to pass them on, after rivals like Blackrock, Vanguard and JP Morgan decided to cover the cost of research themselves.

Outlawing the provision of research will undoubtedly make life difficult to smaller managers, and will throw up barriers to entry in the fund management business.

Brokers and investment banks are likely to see a hit to revenues as investment houses choose not to pay for what was previously an indirect cost. The number of research analysts employed in London could drop by 1,000 from the current level of 6,000.

The issue does raise questions about the value of investment research. Some studies suggest only 1% of investment research is actually read, while most of the time the buy side consumer never gets beyond the first page.

But there are always constraints on time, and someone, somewhere is likely to get some insight from it.

There is no doubt that coverage - and thus visibility - for mid and small companies will drop in future, possibly leading to an increase in the cost of capital.

There may be a boon, though, for smaller fixed income managers, as Credit Suisse and other banks have decided to get round the MIFID II rulesâ?¦ by providing their fixed income research for free.

The opinions stated are those of the author and should not be taken as investment advice. Any recommendations may not be suitable for all, so please contact your financial adviser for further guidance. The value of investments can go down as well as up.

Investment business