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March 1, 2004

The Rise and Fall of Soft Dollars?

By Gregory Bresiger

TowerGroup estimates that the investment management industry spends about $6.6 billion a year on technology. About two billion dollars of that is spent on market data. And about $600 million of that is paid for with soft dollars, Hegarty said. He estimates that total soft-dollars credits come to about $1 billion a year for independent research firms, which doesn't include proprietary research. A Greenwich Associates report estimates that 90 percent of investment advisers use soft dollar arrangements.

Still, this debate begs a simple question - can someone exactly define soft dollars? And, since the proper use of soft dollars is a direct result of obtaining best execution, another subject of great debate, maybe, some traders say, defining best execution is also a futile exercise. Nevertheless, the SEC has certainly tried with best execution regulations going back to the 1970s.

Paul Roye, SEC Director of the Division of Investment Management, in a memorandum last year to incoming SEC Chairman William Donaldson, wrote that best execution is the ability to "execute securities transactions in such a manner that the client's total cost or proceeds in each transaction is the most favorable under the circumstances."

Last year, in a hearing before Baker's House subcommittee, SEC officials said proposals calling for better soft-dollar disclosure were not adopted "because of intractable problems in valuing the research and services that advisers receive for soft dollars." Regulators conceded that it can be quite a task to quantify the "effect of the benefits on the accounts' performance."

Still, making the issue even dicier, soft dollars are only a part of best execution. Commission costs, Aronson maintains, are "the tip of the iceberg." He said that his firm believes that commissions comprise maybe 10 percent of the total execution costs, which includes spreads, opportunity and implementation costs. Nevertheless, rising volumes have made that iceberg bigger. Given the billion plus share trading of recent days, even that ten percent is a large amount, Aronson adds.

Aronson dislikes soft-dollar arrangements and would love to see them terminated. Still, he concedes that soft dollars couldn't be ended without causing huge problems for many firms that are dependent on the practice. Therefore, Aronson is calling for extensive reform of soft dollars.

But what would happen if these involved relationships were to be abolished by the lawmakers? Who would be the winners and losers in any massive cutbacks of soft dollars? First, it is the big brokerage firms that earn "90 percent of the soft-dollar commissions. That is why the SIA is taking such a strong stand against abolishing soft dollars," according to John Meserve, president of Bank of New York's commission research payment services group. "There's not a full-service firm out there that doesn't provide soft dollars," added Meserve. "Hundreds, maybe thousands of analysts would be laid off," predicted Pickard, if soft dollars were abolished.

More Disclosure

"We believe the current system works well," Meserve said, "although we support enhanced disclosure of quantitative information regarding investment advisers' use of client commissions and advisers' brokerage allocation practices."