The New Soft Dollars

Have you noticed that no one in the industry uses the term "soft dollars" anymore? Most people - including the SEC in its recent guidance on "client commission practices" - avoid using the term, perhaps because the practice of obtaining research and other services with client assets has become tainted with past investigations into less-than-ethical behavior that benefits the investment manager and not necessarily the client.

For more than 30 years, buy-side traders have wrestled with the practice of paying for research and other brokerage services with client commission dollars. Why? There can be a conflict of interest between routing trades to certain brokers to pay for research and the money managers' fiduciary obligation to seek best execution at a reasonable cost.

Over the years, the SEC has revisited the use of soft dollars several times, particularly as abuses - such as using client assets to purchase computer hardware, Super Bowl tickets and risquž entertainment at bachelor parties - came to light. When the SEC began to examine the topic again last October, it sent a chill through the industry. There were all sorts of forecasts about how the SEC would abolish soft dollars and money managers would have to pay cash for research. But on July 24 this year, the SEC allayed the industry's fears by clarifying what is eligible under Section 28 (e) of the Exchange Act - the legislation that protects money managers if they pay more than the lowest commission for a trade to obtain research services - for payment with client commissions.

Strong Demand for Soft Dollars

Despite the regulatory chill over soft dollars and cutbacks in soft dollar budgets from mutual fund companies, soft dollar arrangements are pervasive in the economy of research and trading. U.S. institutions spent an estimated $970 million last year on third-party equity research and services other than executions, according to Greenwich Associates' May report. And U.S. institutions expect that level to hold for the coming year.

Further, the SEC's recognition of commission-sharing arrangements, has given the industry more flexibility. Now, U.S. buy-side traders can more easily select a broker based on execution skills, analytics or algorithmic trading technology, while still paying for valuable research through commission sharing.

"This is another flavor of soft dollars that is being used a lot," comments Nitin Gambhir, CEO of Tethys Technology, a financial software developer. One can argue, Gambhir continues, that soft dollars are helping the buy side achieve best execution by providing access to the latest trading tools. For instance, many leading brokers are offering to sponsor execution management systems (EMSs), one of the most sought-after technologies on the buy-side trading desk.

"It's becoming quite common for the brokers to sponsor technology to the buy side" as a way to capture order flow, Gambhir says. For example, if two brokers tell a buy-side firm they will do a trade for 50 mils (1 milicent = one-tenth of a cent), the buy side might be agnostic, he relates. "But if one broker says it will do the business for 55 mils but is also throwing in some interesting TCA or algorithms and charging a single rate," that may become more compelling, Gambhir suggests. "That way, the buy side is receiving something tangible from these guys," he notes.

So despite the pall that was cast over soft dollars last year, the practice continues to evolve and adapt to changes in technology, the electronic markets and regulation. Though there is bound to be more disclosure and documentation involved for the buy side, at least traders can utilize the pre- and post-trade analytics to prove they received best execution - and even pay for that with soft dollars.