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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.

Disclosure on the Rise

An alternative to banning soft dollars could be to require more disclosure of the commissions that buy-side firms are paying and a list of what services they are receiving in return. Then, clients would be more aware of the commissions that are being paid out of investor assets. Without disclosure, investors can't evaluate whether the commissions the manager is paying to brokers is higher than those of comparable firms or if excessive commissions may have a negative impact on the fund's rate of return. "The focus of regulatory change should be to encourage some sort of mechanisms for pricing a broker-dealer's products and services," says Ellen Hunt, chief executive officer of FinancialSockets, a developer of commission-management software in New York City.

"There's certainly a movement afoot to examine broadly what institutional investors are paying for with their commission stream. That's an aspect of not only the United States but in the United Kingdom," says John Colon, managing director of Greenwich Associates in Stamford, Conn. The U.K. Financial Services Authority (FSA) is undertaking an investigation of soft dollars through its Consultative Paper 176.

In the United Kingdom, questions are being raised about which technologically oriented products and services, screens and information feeds are directly related to the investment process, says Colon. "The descriptions of those services need to be directly related to the investment process," he says. There's a growing perception that information feeds, and other technological products that are received constantly, are part of "the infrastructure or plumbing" of running an investment management business, says Colon.

Though U.S. regulators are no doubt monitoring what the FSA is doing, sources say the SEC will not go as far. Yet, if soft dollars were banned or curtailed, it could have a chilling effect on smaller buy-side firms that rely on commission dollars to pay for research and technology, several industry sources warn.

"The way this plays out could have dramatically different effects" on both money managers and technology providers, says Deirdre Noonan, president of Blackwatch Brokerage, a wholly owned subsidiary of Macgregor, the Boston-based provider of trade-order management systems. Since Macgregor's software is "really a mission-critical application and its target market is large institutions," Noonan believes, "They could afford to pay for their services in cash versus soft dollars." Roughly half of Macgregor clients already pay for their services in cash, she adds. Eze Castle's Quinlan says that the SEC may come out with a list of five or six items that are not permissible, including market-data services, hardware and various investment-software products.

John Meserve, president of Westminster Research Associates, a soft-dollar broker owned by The Bank of New York, believes that market-data and software products do fall under the safe harbor, but if they were removed it could create an imbalance between the technical and the fundamental manager. "There are money managers who don't use any fundamental research. They trade on electronic communications networks and they use technical, quantitative strategies that they build on their Bloomberg or Reuters platform," he says. "What's more independent than doing your own analysis using complex databases and analytics?" he asks.

Meanwhile, technology providers to the buy side are preparing for regulatory action. "No matter which way the pendulum stops swinging, you know that there's going to be a ton more of disclosure and a ton more of reporting," says Eze Castle's Quinlan. His company recently purchased The Commission Optimizer, an expense-management platform from BNY Brokerage Services that offers a more granular look at expenses.

Similarly, FinancialSockets offers a product called BrokerSelect, a system that allows money managers to evaluate their trading and brokerage selections. Though the formal commission-management software may have an extra "bell or whistle," Blackwatch's Noonan says most buy-side firms have an internal system or spreadsheet to track commissions. "The absence of those systems is not the problem," she says. The issue, she adds, is the extent to which the same scrutiny is being applied to the lion's share of commissions that goes to pay Wall Street firms for their research.

However, due to the pressure on soft dollars, NeoNet's Kearns predicts there will be an unbundling of the research and execution services provided by the integrated full-service sell-side firms. "The tricky thing is research. That's the biggest question. Soft-ing your technology or your Bloombergs, that's kind of minor," he says. 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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