U.K. Overhaul of Soft Dollars May Tempt SEC Action

A proposal by the United Kingdom's Financial Services Authority (FSA) to prevent U.K. fund managers from paying their research and market-data bills with bundled or soft-commissions, could have broad ramifications for the U.S. fund management and brokerage industry.

A research report by Celent Communications, released last week, contends that any action by the U.K. regulator could prompt the Securities and Exchange Commission (SEC) to follow suit in the United States.

"The FSA is going to ban the process of bundling and soft commissions. Soft dollar arrangements will no longer be legal," says Octavio Marenzi, president and chief executive officer of Celent Communications, who co-authored the report. "If an asset manager wants to purchase research and charge it back to their clients, they'll have to do (so) explicitly," he says.

"Many other countries in Europe recognize soft dollars makes asset management fees somewhat murky. It relieves asset managers from seeking the best execution and prices for their clients," but the FSA is going much further than other regulators on this issue," he says.The FSA's proposal, known as Consultation Paper 176, was published in April, and is currently out for comment. Celent expects the FSA to act upon the paper within the next six months.

The primary motivation is greater transparency of trading costs to shareholders. If U.K. asset managers were no long permitted to pay for third-party research by bundling the hidden cost of research into their trading commissions, these expenses would come out of the management fee. Right now, those costs are either bundled with trading commissions or they are buried under soft dollar agreements with brokers. "The whole system is to hide costs from somebody. It's terribly confusing," says Marenzi.

Already, the SEC has talked about making transaction costs more transparent to investors.

In the U.S., industry sources believe that soft dollars represent $1.57 billion or eight percent of the total $18 billion in commissions paid in 2002, states the Celent report. Bundled commissions could account for another 50 percent of trading revenues, estimates the report. Thus, if U.K.-style softing and bundling regulations were to spread to the U.S., then 58 percent of commissions would be erased, Celent estimates. Total losses to the U.S. brokerage industry could reach $4.5 billion, leaving $13.5 billion for the surviving firms.

One buy side institutional trader is against a radical overhaul of soft dollars though he sees the need for more disclosure.

"Personally, I would hate to see the U.S. go as far as the U.K. is considering going," says John Wheeler, manager of equity trading at American Century. "Our view all along is that it's perfectly okay for shareholders to pay for research through commission dollars. There just needs to be more disclosure about the relationships between the asset managers and the research providers," says Wheeler.

"Without disclosure, you're setting up asset managers free with the shareholder checkbooks. Because of the economics of how asset managers earn their revenues, you create an environment where there is a lot of leverage in the soft-dollar game, where asset managers lay off expenses in the form of commission dollars. It sets kind of an artificial floor on commission rates, because managers don't have an incentive to push the brokers for lower rates when they're getting these bundled services," he says. If the SEC decides to take action on bundling or soft commissions, Marenzi says it won't be as radical as what the U.K. is doing.

Though the SEC did conduct a sweeping examination of soft dollar practices by fund managers and brokers in 1998, it did not lead to major changes. "The SEC is very difficult to predict," says Marenzi, but he says regulators tend to have a "herd mentality."

"Ideally things wouldn't really change that much. It just would be more transparent to what the money is being spent on," says Marenzi.

That means asset managers may try to keep costs under control. "You might see reduction in spending on Bloomberg machines, order management systems and portfolio accounting systems," says Marenzi. "The fact that the asset manager has more market data costs would be more transparent it wouldn't be bundled in with trade execution costs," he adds. Marenzi speculates that high-end service providers such as Bloomberg would be impacted if fund managers became more cost conscious and decided to purchase cheaper bond pricing services.

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