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February 1, 2002

More Soft Dollars Coming to Nasdaq?

By John A. Byrne

The Nasdaq Stock Market may soon see a massive expansion in soft-dollar services offered by dealers. That follows the SEC's approval of eligible riskless principal transactions, which are acceptable in commission' business for research and brokerage services. It is a radical step for Nasdaq.

The soft-dollar industry is the province of agency transactions, a form of business that seems ready to expand on Nasdaq since the introduction of decimal pricing. Until recently, Nasdaq was driven by principal trading, in which dealers made money on spreads. Soft dollars were an insignificant factor. This spread, or net-based trading, however, is no longer a profitable arrangement for many dealers, many of which are suffering through shrinking margins.

Charging Commissions

Now more Nasdaq dealers are adjusting to decimal trading - charging a commission-equivalent,' or a form of commission on trades that are handled on a type of principal basis. It might be semantics, but this practice allows a dealer not to risk the firm's capital. So Nasdaq may now see more soft-dollar programs entering the industry, some pros say. (Soft dollars are huge on the listed markets, which are driven in large part by agency transactions.)

As part of the move toward a new agency environment, the National Association of Securities Dealers modified its trade reporting rules for certain riskless principal transactions. It requires "riskless principal transactions, in which both legs are executed at the same price, to be reported once, in the same manner as an agency transaction, exclusive of any markup, markdown, commission equivalent, or other fee," the SEC noted in a release.

The Securities and Exchange Commission, pressed by Nasdaq, made commission dollars generated by these transactions eligible for soft-dollar services. "Nasdaq urged us to interpret the Section 28(e) safe harbor [of the Securities Exchange Act of 1934] to apply not just to research and brokerage services obtained in relation to commissions on agency transactions, but also to such services obtained in relation to fully and separately disclosed fees on certain riskless principal transactions," the SEC noted in the release.

For money managers who transact orders with dealers on Nasdaq, the SEC says the new arrangements fulfill the goals of the Section 28(e) safe harbor. The SEC notes: "A money manager relying on the safe harbor must determine in good faith that the amount of commission' is reasonable in relation to the value of research and brokerage services received. This requirement presupposes that a commission paid by the managed account is quantifiable in a verifiable way and is fully disclosed to the money manager."

Fees on traditional riskless principal transactions, which are not eligible for soft dollars, can include an "undisclosed fee," which disguises a dealer's profit.