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August 31, 2001

The Soft-Dollar Critic

By Kathryn M. Welling

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Benn Steil is an academic. But not the head-in-the- clouds-type who occasionally writes indecipherable tomes purporting to prove a strong correlation between sun spots and trading activity. Yes, he has degrees from Oxford and Wharton, expertise in international finance and trade, decision theory and risk management.

And yes, he is the Andre Meyer Senior Fellow in International Economics at the Council on Foreign Relations. But he also has actually spent days and days on trading desks and exchange floors, hours upon hours picking the brains of traders, portfolio managers - even regulators, when he can find them (with brains). In other words, his grasp of securities trading extends from the theoretical to the practical, from electronic trading platforms into the pits.

So when Benn recently teamed up with colleague Robert A. Schwartz, a University Distinguished Professor of Finance at CUNY's Baruch College, to study why institutional traders don't really behave in the straightforwardly profit-maximizing way that most egghead models presume, it was probably predictable that the answer they'd arrive at would be grounded in the nitty-gritty of the way the Street works, and not some arcane theory.

Nonetheless, their conclusions, in a piece entitled, "Controlling Institutional Trading Costs: We Have Met The Enemy, and They Are Us,'" which is slated to appear in a forthcoming issue of the Journal of Portfolio Management, are unusually pointed: Institutions frequently pay too much for trades because of the perverse incentives in the soft-dollar commission bundling arrangements that characterize most of Wall Street's dealings with institutional clients.

And those same commission bundling arrangements explain why cheaper, and more efficient electronic trading systems haven't been able to gain much of a toehold vis-a-vis the NYSE.


Benn, you blame soft dollars for lots of the failings of institutional traders - not to mention for the Big Board's market dominance?

Nobody wants to talk about soft commissions. Both the funds and the brokers have enormous incentives to continue the system. They don't want anybody asking questions about precisely what is being paid for with this soft commission money.

But as long as it's a legitimate service - whether trading or research or computer systems - what would be so awful about seeing an honest price tag attached?

We know the answer to that. If the funds paid directly for these things, they couldn't fund those payments out of their client's assets; they'd have to use their own. I mean, the only reason they do it through soft commissions is that it's a legal mechanism to transfer the costs from themselves to their clients-

Who are oblivious -