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January 2, 2014

Mixing Soft Dollars and Bitcoin?

A proposal to use the virtual currency for brokerage fees could be too tempting for those in the financial arena.


Robert Stowsky

Around the turn of the current century, I was hired by an investment management firm with just north of $300 billion AUM as a program manager overseeing trading systems development. I had about 30 project managers, business analysts and programmers reporting to me and an annual budget well into the seven figures. The only catch was that I wasn't hired as an employee of the firm.

Instead, I was a contractor whose hourly expenses were billed to a broker as part of a soft dollar agreement, also known as a client commission agreement (CCA) in the U.S. or commission-sharing agreement (CSA) elsewhere. This guaranteed a minimum amount of equity order flow by the investment manager to the broker in exchange for the broker picking up the tab for me and a number of other contractors in the IT department. Other soft dollar agreements between this firm and other brokers paid for the other contractors in my budget.

This was all done under Section 28(e) of the Securities Exchange Act, the so-called "Safe Harbor" that allowed investment managers to use commission dollars to acquire research and other services from their brokers. Most investment managers at that time were using soft dollars to pay for research reports and market data feeds. Others, like the firm that hired me, decided to park an aircraft carrier in that safe harbor and use soft dollars to cover most of their IT staffing.

Like many parties in the investment industry, this one wouldn't last. In the early 2000s, a number of fund managers were accused of paying excessive commissions to brokers in exchange for the brokers giving them preferential treatment in distributing funds. This "revenue sharing" violated specific NASD (now FINRA) rules prohibiting such agreements. It also threw a spotlight on how investment managers and brokers negotiated commissions in general and raised questions about whether these agreements were always in the investors' best interest.

Public pressure and a few SEC reinterpretations later, firms began to limit their use of soft dollars to avoid customer revolts.

Larger firms began to pay directly for research and other services and even began to campaign for restrictions on soft dollar use after they realized some of their smaller competitors couldn't survive without having soft dollars to pay for their Bloomberg terminals. The SEC responded by creating a very shallow safe harbor that only allows eligible research which it defined as "advice, analyses or a report." By the mid-2000s, buyside firms were limiting their CCAs to a small number of large brokers. These agreements are like bank accounts where credits accumulate that can be used to pay for research from third parties. They also require the buyside to tell the counterparty where to direct the payment for the desired service. CCAs have expanded from domestic equities to include foreign trading activity, as well as including trading activity for other asset classes outside of equities.

After the collapse of Lehman Brothers and Bear Stearns, the buyside is now looking for solutions that would allow their credits to survive even if the counterparty doesn't. There has been talk about creating a central depository for CCA credits. The idea is that a buyside would be able to aggregate their credits from multiple counterparties into a single account and not need to communicate to the counterparties where credits are being spent.

George Kledaras at FIX Flyer recently proposed including an actual bitcoin payment as part of a FIX trade confirmation message, possibly eliminating some of the complex commission accounting and separating the credit from the counterparty.

Perhaps a new virtual currency specifically for use under Section 28(e) would address any concerns of using a freely floating virtual currency like bitcoin. Something pegged to a fixed value redeemable only for eligible research may be a more workable approach.

FINRA-coin, perhaps?


Robert Stowsky is senior analyst for Aite Group.


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