The elimination or curtailment of the use of “soft dollars” will have deleterious effects on both the brokerage and the fund management industries, says Tower Group. The research consultancy says that the securities industry is currently so dependent on the flow of soft dollars, whether for the provision of research to fund managers or for the provision of order flow to the brokerage industry, that rapid elimination of soft dollars could paralyze the securities industry.
Tower Group argues that greater scrutiny and transparency of soft dollars- defined by the Investment Company Institute (ICI) as “credits” that result from arrangements between broker-dealers and investment advisers, where the broker provides the adviser with both the execution of client brokerage transactions and research-related products and services – is desirable. But it says the sheer size of the US capital markets, combined with the industry’s enormous reliance on soft dollars, means a rapid deceleration in soft dollar use would force buy-side firms to find hard dollars to pay for required research and services, while eliminating an entire sub-industry of soft dollar brokers.
Should soft dollars to pay for research disappear, predicts Tower Group, fund managers will become stingier with the IT budgets that support the research and investment decision-making process, since much of these technology budgets are funded through soft dollars. Areas within the firms that would feel the greatest impact include market data spending (whether for real-time data, historical and fundamental data, or research), software/application spending for “front-office” systems (such as analytics and decision support tools), and contract programmers hired with soft dollar allocations.
Tower Group notes that the rapid elimination of soft dollars could also lead to order flow shifting more quickly from brokers to electronic venues (where buy-side firms are more likely to have lower trading/transaction costs), as well as reducing reliance among fund managers on external research. The firm says that, even without regulatory intervention, soft dollar spending is set to decline by more than 11 per cent over the next five years.
“Whether you approach this issue as a proponent or adversary, changes in the soft dollars process must be considered carefully and implemented in a well-thought out, phased approach,” says Rob Hegarty, vice president of the Securities & Investments practice at TowerGroup and author of the research. “Because soft dollars are so entrenched in the brokerage and asset management industries and their inter-operation, their rapid elimination would constitute a hard landing for all parties. A better approach might be to increase soft dollars reporting requirements while laying out a plan to gradually phase out their use – or even to shift soft dollars arrangements to look more like a consumer reward program such as a frequent flier program, where soft dollars are earned as you go, not committed up front.”
Hegarty noted that over time, TowerGroup expects highly-valued research services currently paid for with soft dollars to be purchased with hard dollars. “This will undoubtedly lead to a shake out among less valued research providers,” he says.
The TowerGroup ViewPoint is entitled “The Elimination of Soft Dollars: A Hard Landing for the Securities Industry, Including Technology Spending.”