New York, NY – According to a recent research report published by Greenwich Associates, institutional investors’ use of third-party soft dollars is expected to rise from 7% of total commission payments in the year ended February 2007 to 10% of all commission spending in 2008.
This expected increase in the use of client commissions to pay for third-party services follows a significant decline this past year, as third-party soft dollar use fell from 9% of all commissions in 2006 (or $970 million) to 7% of all commission in 2007 (or $725 million).
One of the primary reasons for the decline in the use of soft dollars by buy-side institutions has been the regulatory uncertainty that has prevailed in the marketplace over the last few years.
In recent years, this uncertainty led many buy-side investors to give up the use of soft dollars altogether, with money managers like Janus and MFS internally banning the practice. In 2004, more than 80% of institutional investors used soft dollars to pay for third-party services. This total fell to 62% by 2007.
Another trend that has been impacted by this uncertainty has been institutional investors’ use of hard dollars to pay for research. The Greenwich survey showed that the buy-side spent $445 million in hard dollars on equity research for the 12 months ending February 2007, up from about $260 million in the previous year.
It is interesting to note that even though hard dollar totals increased sharply in the past twelve months, the number of institutions buying equity research with hard dollars fell from 35% in 2006 to slightly less than one third of all firms in 2007.
The SEC finally weighed in on the topic of soft dollars last July when they issued their interpretive guidance on the Section 28(e) safe harbor. In this guidance, the SEC reiterated that client commissions could be used to pay for research and execution services on behalf of their clients, while clarifying the definition of what products and services would be deemed to be research or execution.
Another topic the SEC clarified in the past year has been the use of Commission Sharing Agreements (CSAs) and Client Commission Arrangements (CCAs) in the US. These agreements enable money managers to work with an executing broker to create a pool of commissions that can be used to pay for research services produced by third-party providers.
In fact, Greenwich discovered that approximately 30% of all institutional investors have set up CSAs and CCAs with brokers, and 60% say they will have one in place within the next 12 months. Analysts at Greenwich Associates add that two-thirds of the market’s largest institutions and most active traders expect to have a CCA in place by the end of 2007.
One of the primary reasons buy-side investors are planning to boost their use of soft dollars in 2008 is their growing belief that the SEC will not make any drastic changes to soft dollar regulations in the coming years.
This view is encouraging given SEC Chairman Christopher Cox’s comments in June of this year that the Congress should consider either repealing or greatly diminishing the safe harbor provision that governs exchanging research services for trading commissions. However, recent comments by various congressional leaders, including Charles (Chuck) Schumer, D-NY, have made it clear that congressional action on soft dollars is highly unlikely.
One topic we think the SEC will start to pay much closer attention to in the coming year is managers’ FORM ADV filings. In the past, senior enforcement officials have noted that many money managers have been confused about what comprises soft dollars, reporting that they use little or no soft dollars.
Of course, this only makes sense if these managers do not pay more than the cost of execution (.05 to 1.5 cents per share) for their trading, and they do not receive “free” Wall Street research from these execution partners.
In addition, we suspect that the SEC will once again refocus its efforts on trying to address the issue of commission transparency – a topic the Commission originally expected to deal with by the end of 2006.
Comment by BM: There is another way for a fund to claim that they do not use soft dollars, yet still receive pure execution pricing and “free” research access. The strategy involves ramping up trading volume with the broker so that the total commission dollars will yield enough revenue to the broker to cover the price of research services.
In the end, the research and execution broker cares about total commission dollar revenues and not the rate per share.