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Get Tough on Soft Commissions

Author: Benn Steil, Senior Fellow and Director of International Economics
December 21, 2004
Financial Times

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Over the past decade, billions of dollars have been funnelled through middlemen and kicked back into the pockets of the regime, right under the eyes of the authorities charged with ensuring that the money was spent properly on the people's behalf.

The Iraqi oil for food scandal? No. This is the securities industry soft-commissions scam.

The regime is the mutual funds, the middlemen their brokers and the people their investors. Although government interest in the scam is largely confined to the US and the UK, this is simply because the practice is so entrenched elsewhere that it is considered the normal way to do business.

The system works like this. Investors send money to mutual funds. The funds levy, say, a 1 per cent management and expense charge, and the investors typically assume that the remaining 99 per cent of their money is invested in the market on their behalf. But it is not quite like this. The funds are also allowed to deduct the commission charges they incur in buying and selling shares on behalf of their investors. So far, so reasonable.

A US mutual fund can execute trades in most domestic stocks for about 0.5 cents a share using electronic agency brokerage systems. Yet they choose to do most of their trades with traditional brokers at about 5 cents a share. Why?

Roughly 3 cents a share is "refunded" to the fund manager in the form of what the industry calls "research" - an arrangement known as soft commissions. The research is either provided by the broker itself, or subcontracted to a third party. The broker pockets the other 2 cents. But why would the funds buy research through trading commissions, rather than carrying it out themselves or paying consultants directly? Because if they did so, they would have to use their own cash. When they pay through commissions, they use clients' cash instead.

What the industry calls "research" includes not just information and opinions on companies and the wider market, but also things such as computers, printers, network support, newspapers, online services, conference registrations and accounting and proxy services. Essentially, the mutual funds are using trading commissions to cover their most basic operating expenses out of client money, without the clients knowing. And this is just the stuff the Securities and Exchange Commission says is legal, or "research-related". Rent and vacations have also been known to figure in the package.

In the construction industry, such a practice would be called a kickback and those responsible would be ruthlessly prosecuted by government authorities. In the Iraqi oil for food programme, it is the subject of a United Nations inquiry led by Paul Volcker, the former Federal Reserve chairman. But in the mutual fund industry, it goes on unchallenged.

Or almost unchallenged. Over the past year, both Houses of Congress have made muted noises about it, and in 2005 are likely to admonish the SEC to crack down on the most conspicuous abuses. But why has the SEC not done so on its own initiative? Because virtually the entire securities industry benefits from the practice and has lobbied for its preservation.

How much does this cost investors? Recall the market-timing scandal pursued by Eliot Spitzer, the New York State attorney-general. Market-timing abuses have been estimated to cost investors about five basis points, or 0.05 per cent of funds under management. By way of comparison, my research indicates that the cost to investors of their funds picking brokers on the basis of kickbacks rather than efficient execution is at least 70 basis points. And this estimate assumes, generously, that a dollar of services kicked back to the fund manager is actually worth a dollar to the investor. It measures only the cost of bad trading.

So what is the solution? Ban soft commissions? That sounds good - but fund managers and brokers would still have strong incentives to disguise kickbacks as "free" services provided in return for inflated commissions.

The only watertight solution is to get the incentive structure right by transferring responsibility for the trading commissions from the investor to the fund manager. If fund managers had to bear the cost of trading commissions, they would immediately unbundle trade execution from other services and haggle with brokers, research providers, data vendors and the like about the cost of each service. I estimate that fund managers would have to raise management fees by about 18 basis points to cover these costs. But if soft-commission trading is costing investors at least 70 basis points, this would still leave investors better off by more than 50 basis points.

Not surprisingly, both the US and UK fund management, brokerage and "independent" research industries have resisted this idea. So I now present a second-best option: expand soft commissions beyond the brokerage industry and allow telecommunications, electricity and other companies to compete for the business. Instead of a fund paying a broker 5 cents a share for trades worth only 0.5 cents a share, a US fund could pay Verizon, or a British fund could pay BT Group, $50,000 (£25,700) for monthly telecom services worth $5,000. Verizon and BT would then buy $30,000-worth of "research" services, kick that back to the funds and pocket a $15,000 middleman profit.

This would benefit investors enormously. That is because the funds would finally start choosing brokers on the basis of ability to provide "best execution", rather than the composition of the kickback package, thereby wiping out the 70 basis point premium investors currently bear.

If this still sounds like corruption, that is because it is. But the fact that it highlights the impossibility of best execution in the current environment, with brokers at the centre of the kickback process, should indicate precisely why reform is so badly needed.


The writer is a senior fellow in international economics at the Council on Foreign Relations.

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