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Regulators Play Hardball with Soft Dollars

Buy-side firms are facing more disclosure requirements and possible curtailment of soft-dollar commissions applied to investment technology.

Soft dollars are on the hot seat once again. Pressure is building for regulators to examine the rules that govern the use of soft dollars - the practice of paying for third-party services, including independent research and market-data services, with commission revenue, rather than through direct payments, known as hard dollars.

Why are soft dollars under scrutiny? Because investment managers' clients are unrightfully footing the bill for the buy side's research, market data and technology. The issue is threefold. First, brokers' commissions are being raised to cover these expenses. Second, when the commissions are paid, they come out of the investment manager's assets under management, which could alter the performance of the fund. Lastly, in addition to being a cost to investors, soft dollars are in direct conflict with a buy-side firm's best-execution obligations since investment managers have an obligation to monitor the quality of executions, including trading costs and market impact. A money manager who is sending customer order flow to a broker to obtain research and technology is not focusing on getting the best execution for his or her client.

In December, the Investment Company Institute (ICI) proposed that the Securities and Exchange Commission ban the use of soft dollars by mutual-fund companies to pay for third-party services. Janus and MFS, two mutual-fund companies investigated for late trading and market-timing practices, indicated they would no longer use soft dollars.

Leery of a new scandal, "The ICI took a very extreme stance against soft dollars in the shadow of the mutual-fund scandal," asserts David Quinlan, president of Eze Castle Software in Boston.

Though the SEC has not taken specific steps regarding soft dollars, Chairman William Donaldson has talked about it in general terms as an issue he may focus on in the future.

Even though the ICI has called for a ban on soft dollars as they apply to mutual funds, the practice is protected under the law as long as investment managers look at best execution when they choose their brokers. Section 28 (e), an amendment to the Securities Exchange Act of 1934, passed in 1975, allows money managers to pay higher commissions for a trade in return for research services, if they believe the value of the research is beneficial to the underlying owner of the asset. The rule, which is termed a "safe harbor," was broadened in 1986 to allow for purchases of market data and other technology related to investment decision making.

According to Greenwich Associates, the top 400 U.S. institutional money managers are spending about $1 billion, or 12 percent of their total commissions, to pay for third-party services, including independent research and technology.

While industry sources are not expecting the SEC to ban the practice, they are expecting some modifications. "I expect we'll see a stricter definition of what soft dollars encompass, and we'll probably see increased disclosure of soft dollars. Right now, it's not a very transparent industry," says Robert Hegarty, vice president of TowerGroup's securities and investments practice.

"There is most certainly some amount of loose interpretation of soft-dollar rules, as well as some very direct conflicts between achieving 'best execution and employing soft dollars,' " writes Hegarty in a recent report. If soft dollars go away or are reduced, Hegarty predicts that buy-side firms will do more trading through electronic venues.

Peter Kearns, president of international agency-broker NeoNet's U.S. operations, says, "You're not getting best execution [when using soft dollars]. That's exactly why firms like NeoNet are growing market share." NeoNet's firm provides direct-market-access trading to institutions. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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