The Soft Dollar Threat

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Currently there is substantial airtime being given to the issue of soft-dollars and what to do about them from a regulatory point of view.  On April 21, 2004, the US Senate committee on Banking, Housing and Urban Affairs concluded hearings regarding soft dollars i.e. whether to ban them altogether or to mandate greater disclosure of soft dollar payments by both research firms and their buy-side customers.  Since then, the SEC has taken up the charge, forming as Task Force to investigate the issue.

Proponents of soft dollars naturally highlight the fact that soft-dollars are just another form of payment for services offered and that the regulators should not step in.  On the other hand, opponents of this stand contend that the fact that soft-dollars are not taken out of the fund managers’ expenses makes managers less careful with investors’ money.  A number of market participants argue that using soft dollars has led to a consistent overpayment for research services since they are not really footing the tab for the research, investors are.  Still other opponents of soft dollars note that the practice has spawned an entirely new class of products and services that are paid for using soft dollars. The items include premium club memberships, publications available to the general public, computer hardware and software, etc.

While the regulators have yet to decide or announce any significant move, this issue could pose a threat to a broad range of market participants.  Any proposal to eliminate soft dollars for third-party research BUT NOT address commission bundling, would have unfortunate results for independent research providers as it would virtually establish a regulation-backed competitive advantage for full-service brokerage firms vis-à-vis third-party research providers.

Such a result would be paradoxical in view of the problems that have been uncovered during the past few years relating to conflicted research provided by various sell-side firms. Many advisers believe that third-party research provided by independent firms is of higher quality than propriety research provided by large Wall Street brokerage firms. Additionally, using soft dollar credits for third-party research is definitely more transparent than “paying up” for proprietary research from full-service brokers bundled with execution services.

Eliminating soft dollars across the board would be extremely difficult for the smaller indie research providers, as most of them don’t have the scale and the marketing resources to be able to compete with their larger independent and sell-side brethren. As a result, a number of boutique independent research providers would likely close up shop in the face of a ban on soft dollars.

In addition, getting rid of soft dollars would have adverse consequences for mid and smaller money management and investment advisory firms that depend on sell-side and third-party research and don’t have the resources to build their own internal research departments.  These firms would also be forced to consolidate or risk going out of business due to their inability to compete.

If the regulators eliminated bundling (or promoted rules that eventually led to the break down of bundling), then the sell-side would surely suffer – leading to sharply reduced research budgets, layoffs among research analysts, and in some instances, firms exiting the research business altogether.

Many small and mid sized corporations could also suffer as their ability to obtain research coverage would probably wane in light of the reduced research staffing and slashed coverage universe that would take place in Wall Street research departments.

Of course, all other things being equal, banning soft dollars would definitely lead to an increase in the investment returns seen from retail investors’ mutual fund purchases – OR WOULD IT?  It cannot be argued that eliminating the soft dollar expenses charged directly to investors’ assets would not benefit investors.

However, it is unclear if eliminating the research used by institutional investors (an outcome that would surely take place if they were forced to pay hard dollars for this research), would lead to higher or lower investment returns.  In fact, some suggest that eliminating soft dollars would reduce the overall research available, to the detriment of both professional and retail investors.

In fact, it seems that the principle beneficiaries of eliminating soft dollars would be the largest fund managers who would benefit tremendously from being able to obtain “transaction only” commissions from the largest Wall Street houses.  They would also enjoy the reduced competition resulting from the exit or consolidation of many small or mid-sized money managers who don’t posess the economies of scale to produce their own research.  You see, the large money managers could offset the reduction in Wall Street and indie research by building up their internal research departments.  And who knows, they might even be able to pass on higher fees to the retail investor as a result of this increased cost of doing business.

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