Hedge Fund Question of the Week – Summer Edition – No. 9

What will happen to “soft dollars”?

Answer:  The practice will go away, eventually.

For the future of soft dollars, look to the EU and MiFID II.

As background, Congress ushered in the practice of soft dollars with the enactment of Section 28(e) in 1975.  The provision allowed buy-side managers to pay more than the lowest available commission rates without violating their fiduciary duty in return for bundled execution and research.  This action came at a critical moment when fixed commission schedules were abolished and negotiated commissions were instituted.  Section 28(e) was originally intended to protect the brokerage industry’s proprietary research departments which might otherwise become unprofitable.   

Enter MiFID II and its research directive in 2018.  In short, MiFID II requires EU managers to pay for research with hard dollars, either with their own money or with separate research payment accounts funded by clients.  It also necessitates the unbundling of execution and research costs.  Given the international impact of MiFID II, the SEC released temporary measures to address a resulting set of thorny U.S. regulatory issues.  If it can work through these issues, the SEC might eventually follow the EU lead.