This is the first of a two-part series examining the policy implications of restricting the use of client commissions to pay for research.
Recent regulatory actions in Europe have focused attention on the conflicts associated with paying for investment research with client commissions, but, other than industry warnings of unintended consequences, we haven’t seen much thought given to the policy implications of restricting the use of client commissions for research. The existing rules provide a subsidy for equity research, and as with any subsidy, there are both costs and benefits.
Rationale For Soft Dollars
The safe harbor of Section 28(e) of the US Securities Exchange Act of 1934 was created to provide an incentive for broker-dealers to produce equity research. As the US Securities and Exchange Commission phrased it in its 1986 interpretive release: “In adopting Section 28(e), the Congress acknowledged the important service broker-dealers provide by producing and distributing investment research to money managers.”
The impetus for Congress to pass the bill was the abolition of fixed commissions in the mid-1970’s. In the previous era of fixed commission rates, when broker-dealers could not compete on the basis of the commissions, brokers competed on the basis of their research services. There was widespread concern that when fixed commissions were abolished legislatively as part of the Securities Acts Amendments of 1975, that broker-dealers would have fewer incentives to produce research, and the volume and quality of research would decline.
A 1975 Senate report[1] articulated the rationale for the safe harbor: “The future availability and quality of research and other services in an environment of unfixed rates could be jeopardized, with potentially harmful consequences to all investors.”
The Subsidy
In creating the safe harbor for paying for research with client commissions, lawmakers and regulators did not envision how large the soft dollar subsidy might grow. Since the mid-70s, US mutual fund equity assets have grown from $37.5 billion in 1975 to $8.1 trillion in 2015, according to the US mutual fund trade association, the Investment Company Institute.
The size of the soft dollar subsidy has also grown. Greenwich Associates estimates that bundled commission payments total about $8 billion globally of which 60% or about $4.8 billion is notionally allocated toward research. Commission sharing agreements account for another $5 billion globally according to Greenwich, of which approximately $3 billion is research. Thus, the subsidy for research is around $8 billion, according to the Greenwich surveys.
The fact that the subsidy grows as commission volumes increase is precisely what unnerves European regulators. Why should the cost of research grow just because trading volumes increase? The question makes sense when applied to an individual asset manager, as long as the scope of its investments hasn’t increased. But when we view the broader market, there is more logic to an expanded subsidy as new funds and new asset managers are created, as investment strategies expand, and as the number of investment options increase.
Fixed Income Research
Another lens to view the soft dollar subsidy is to view a related market where there is no subsidy: fixed income research. Because broker-dealers in fixed income markets are compensated by transaction spreads rather than commissions, there is no widely used analogue to soft dollars for fixed income investments. Some asset managers use equity commissions to pay for fixed income research, but the volumes are not large.
We estimate spending on fixed income research at around $1.5 billion, which includes spending on research from credit rating agencies, independents such as CreditSights, and an estimate for spending on broker-dealer fixed income research. If so, the spending on fixed income research is less than one-fifth the spending on equity research.
As a result there are far fewer sources of fixed income research. We track just under 380 fixed income research sources in our proprietary ResearchSelect database, a sharp contrast with the over 1,670 equity-related research firms we monitor.
Moreover, there is also an extraordinary diversity of equity-related research, ranging from primary research services such as expert networks, channel checkers or market research firms to forensic research firms to alternative data firms and geospatial analysis.
Broader benefits?
So what exactly are the ‘harmful consequences’ lawmakers envisioned when they enacted the soft dollar safe harbor? Presumably the benefits of more investment research are greater equity market transparency, more liquidity and more efficient markets.
In the theory of efficient markets, information is an important determinant of market efficiency. One of the core propositions of the theory is that the probability of finding market inefficiencies increases as information costs increase. Conversely, if information costs decrease, so do market inefficiencies.
Therefore, the soft dollar subsidy which stimulates the production of more research arguably makes equity markets more efficient. And if that is true, the subsidy also makes passive investments more effective. What a great paradox that is: soft dollars help the index funds who eschew soft dollars.
Meanwhile, US regulators have spent much time and taxpayer money trying to remove information advantages under nebulous rules forbidding inside information. It is an article of faith among regulators that information advantages are generally bad, and that non-public information is inherently suspect, if not downright evil. Given this regulatory bias, a research subsidy designed to increase the amount of information in the public domain makes perfect sense.
In our next and concluding article, we will consider other benefits of the research subsidy, its perverse effects, and conclude with how the policy implications of the subsidy might impact future use of soft dollars.
[1] SENATE REPORT NO. 94 – 75; 94TH CONGRESS, 1st Session; S. 249, Section IV, Payment for Research Services with Brokerage Commissions (April, 1975).