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Hard Times for Soft Dollars

Soft dollars are a means of paying brokerage firms for their services through trade commission revenue. To cover fees for research, for example, buy-side firms direct order flow to the sell-side service provider, which charges inflated trade commissions.

Why It's Important: Changes to soft dollar practices are of interest to both sides of the Street since the tightening of the Securities and Exchange Commission's safe harbor clause -- which details what may be paid for with soft dollars -- will require the buy side to shell out hard dollars for more goods and services. In addition, although it has not been mandated by the SEC, the unbundling of commissions (such as Fidelity's and Lehman Brothers' $7 million October 2005 unbundling deal), which breaks out execution and research fees, would require the sell side to affix a value to each of its research products.

Where the Industry Is Now: The industry currently is in a state of transition in regard to soft-dollar practices. Though buy-side firms are loathe to give up an essentially cost-free way of paying for expenses -- costs that by many accounts should come out of their profits rather than investors' pockets -- first movers are eliminating the use of soft dollars, making it difficult for the rest of the industry to continue with existing arrangements because of resulting consumer perception.

Focus in 2006: Fidelity Investments' decision to pay Lehman Brothers separately for trade execution (passing the charge along to clients) and research (out of its own pockets) single-handedly transformed the idea of unbundling from debate to reality. This year, firms will wrestle with unbundling and associated pricing of services, reduce the types of goods and services they consider legitimate under the safe harbor clause, and seek to automate soft dollar tracking to ensure an audit trail for regulators.

Industry Leaders: The leading firms that have taken a public stance on soft dollars include: Fidelity Investments, which no longer uses soft dollars for market-data services and, late last year, inked the deal with Lehman Brothers to pay separately for execution and research; MSF Investment Management, which no longer uses soft dollars for research and other services; Morgan Stanley, Janus Capital and Bank One Corp., all of which have ended soft-dollar commission payments for outside research; Merrill Lynch Investment Managers, which narrowed its definition of soft dollars, halving the credit generated in this area; Putnam Investments, which asked the SEC to ban soft dollar practices; Bridgeway Funds, which ended use of soft dollars; and American Century and Vanguard, which do not use soft dollars.

Technology Providers: Soft dollar management applications can be crucial to establishing an audit trail for regulators and plan sponsors. Providers include: Eze Castle Software, whose clients include The Boston Company Asset Management, Tudor Investments Corp. and Lee Munder Capital Group; Rontech, whose clients include BNP Paribas Asset Management, Universities Superannuation Scheme (USS) and Hermes; Cogent Consulting, which claims 20 buy-side clients, including AIM Investments; and Financial Sockets.

The Price Tag: Greenwich Associates estimates that soft dollars is a $1 billion-a-year business, while Celent Communications puts the figure at $1.8 billion. Placing a cost on a commission-management system and its implementation is difficult because costs vary according to the size of the firm, the number of system connections required, and the amount of bells and whistles chosen. In general, implementations take between three and five weeks. <<<

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