Soft Dollars Catch a Chill from Potential Regs

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According to a research report published this week by Greenwich Associates, U.S. investment managers and mutual funds slashed their use of soft dollars this past year in anticipation of potential regulatory moves, with many planning to continue reducing their use in the near future.

The new report reveals that soft dollar transactions declined a full 18% to $1.24 billion in the latest year — a steeper drop than the 11% fall in overall equity trading commissions seen during that period.  Greenwich Associates projects that U.S. investmentment managers and mutual funds generated $11.3 billion in equity trading commissions in the past year.

“The declines in soft-dollar usage reflect the expectation that in the current environment, soft dollars are unlikely to escape regulatory action,” says Greenwich Associates consultant John Colon.  “As the perception takes hold, we expect to see even deeper cuts in the future, either in the form of across-the-board reductions in soft dollar usage, or in the paring back of the types of research and services purchased with soft dollars.”

This trend cannot be encouraging to the wave of independent research firms who  rely on soft dollars to support their often fledgling operations.  Our estimates suggest that between 85% to 90% of most institutionally oriented independent research firms’ revenue comes in the form of soft dollars.

Some indie shops have explained that many buy-side investors are reducing their use of soft dollars because “they don’t want to wake up tomorrow on the front page of the Money & Investing section of the Wall Street Journal”.  Regardless, these fears have started to cast a very real pall over the independent research industry.

Based on numerous conversations with research firms and buy side investors, we sense that one of the worst possible outcomes for the marketplace would be if the regulators chose to drag out a decision regarding soft dollars.  Such a development would inevitably lead more money managers to sit on the sidelines regarding soft dollars, resulting in even more fear and trembling among indie firms.

Of course, one potential option for regulators is to demand increased transparency about soft dollar expenses from money managers.  Such an action, however, would have a limited impact unless they required all research providers — including both sell-side and independent shops — to provide institutional investors and their retail investor shareholders with information regarding the cost of the research they purchase using commission dollars.  We believe that a move like this would be a great first step to clean up the soft dollar mess and it would clearly provide investors with the data required to make informed investment decisions.

Wall Street investment banks, however, would not be terribly excited about such a prospect.  In fact, regulating research transparency from brokerage firms would probably produce defacto unbundling as institutional investors (and their shareholders) would finally have the leverage to push for even lower “transaction only” commission rates.  This could only have the result of causing sell-side firms to slash their research budgets and their coverage list further.  Who knows, a few Wall Street firms might even go so far as to decide to quit the research business altogether.

Comment by Al Thompson:

I agree with both your and Mr. Mayhew’s comments regarding the future of the sell-side research department.

I think much will be learned about the future as events unfold in London regarding the recent FSA announcements addressing softing and unbundling.

The investment banks face a real dilemma. Bundled research is used by the firms as a tether to their institutional clients. Yet it is these very clients who are forcing ever greater commission reductions by the banks, and thereby reducing or eliminating the profitably of that product line.

I believe that Goldman’s deliberations are entirely appropriate and suggests that the “all things to all people” approach may no longer be the way to go; especially if it is unprofitable.


Comment by Shiva Badruswamy:

The comment by Michael Mayhew succinctly captures the forecast that bodes sell side firms research departments. I see a couple of different dynamics in play. Technology has made available enormous amounts of research at different price levels. There are several different flavors and aggregators are doing a good job bringing these people together. In such scenarios, I believe the process of price discovery would automatically happen through a direct buy side market place. So the first problem of valuing research will slowly go away. As Mike has rightly pointed out, the second issue of Wall Street firms increasingly slashing their budgets due to regulatory constraints will continue. The buy side firms will also be more reluctant to buy tainted research. Also, many industry magazines have given top ratings to independent research even in terms of making money. I see a market mechanism where only the research houses with a good value-add continuing to survive. Prices will probably be dictated by the quality of research and ratings of the firm. Given the same quality, firms that can produce it at lower costs should prevail.

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