The Economics of Soft Dollars: A Review of the Literature and New Evidence from the Implementation of MiFID II

Howell E. Jackson is the James S. Reid, Jr., Professor of Law at Harvard Law School and Jeffery Zhang is an Attorney in the Federal Reserve’s Legal Division. This post is based on their recent paper. The views expressed in this post are those of the authors and do not necessarily reflect those of the Federal Reserve or the United States government.

For nearly half a century, the bundling of research services into commissions that paid for the execution of securities trades has been the focus of both policy discussion and academic debate. The practice whereby asset management firms make use of investor funds to cover the costs of research, known as “soft dollar” payments in the United States, resembles a form of kickback or self-dealing in that the payments allow asset managers to use investor funds to subsidize the cost of the asset managers’ own research expenses. On the other hand, the production of information on the value of securities arguably promotes the development of capital markets and might be understood as a public good, benefiting both investors and the economy more generally. These competing perspectives on bundled commissions have, over the decades, produced a standoff between investor advocates in favor of unbundling and financial industry interests committed to retaining a familiar, albeit opaque, business practice.

On January 2, 2018, the European Union (E.U.) unbundled securities commissions for large swaths of the European capital markets with the implementation of an E.U. directive known as MiFID II. This unbundling has had a dramatic impact on the cost and production of research in European markets. The implementation of MiFID II also has had a significant consequences for the global financial services industry, including asset managers and investment banks doing business in both E.U. and U.S. markets. Just prior to the adoption of MiFID II, industry representatives scrambled to obtain relief from the U.S. Securities and Exchange Commission (SEC) to accommodate compliance with two different sets of legal requirements, and, on November 4, 2019, the SEC extended that relief through 2023. Notwithstanding these accommodations, MiFID II already has had a material impact on U.S. capital markets. A number of global asset managers have chosen unbundled commissions on a worldwide basis, and a handful of domestic U.S. asset managers have followed suit, bringing themselves in line with what might be perceived to the emerging best practices in the area.

Beyond its temporary relief to accommodate industry compliance with conflicting requirements, the SEC has so far taken a wait-and-see attitude with respect to its own regulations regarding soft dollar payments. While some have argued that the SEC should conform with MiFID II unbundling requirements, others—particularly representatives of the financial services industry—have cautioned against such a move, pointing to concerns that MiFID II may have hampered the efficiency of European capital markets, especially for small and medium-size enterprises (SMEs).

In parallel to the practical and policy challenges that MiFID II poses, there has emerged a theoretical debate over the social value of bundled commissions. The dominant academic perspective on bundled commissions and soft dollar payments is that these practices constitute an agency problem between asset managers and investors whereby the securities industry exploits information asymmetries to extract excess rents with inefficient pricing arrangements. A minority view, however, claims that these arrangements are, in fact, efficient and may also improve the quality of capital markets by producing information to an extent that would not be obtained in the absence of these arrangements. Specifically, without bundled commissions, investors would spend less than is socially optimal to discover information on certain firms, particularly SMEs. This decline in valuable research would, in turn, reduce overall market efficiency. Thus, some argue that soft dollars provide a public good by subsidizing analyst research.

Prior empirical studies of the matter exist but have been limited, in part because good datasets about unbundled commissions have not generally been available to independent researchers. With MiFID II, however, a natural experiment has been created and a number of academic studies have been undertaken since 2018 to explore the impact of reforms on European markets. Unlike industry surveys, which paint a gloomy picture, these academic studies demonstrate that MiFID II has lowered the aggregate level of analyst coverage with respect to large companies—through reduced redundancy—but not with respect to SMEs. Moreover, the studies suggest that MiFID II has increased the quality and impact of analyst coverage. Our own empirical analysis on the evolution of bid-ask spreads strongly supports these findings. Thus, it is unlikely that the implementation of MiFID II resulted in a negative capital market impact on SMEs. Of note, recent research by the European Securities and Markets Authority (ESMA) also supports this conclusion. In particular, the ESMA report shows that increases in the number of companies no longer being covered by research analysts appear to be a continuation of a long-term trend, not the result of a policy that suddenly changed in early 2018.

In light of the ongoing market turmoil caused by the unprecedented COVID-19 pandemic, the European Union is planning to roll back its MiFID II restrictions on SMEs. The European Union would allow payments to be re-bundled for research on companies that do not exceed a market capitalization threshold of €1 billion over a 12 month period, though the European Union would still retain transparency requirements for research costs, which still represents a substantial change from pre-MiFID II requirements. In discussing its policy options, the E.U. staff should weigh the totality of empirical evidence, not just the industry surveys conducted since 2018.

In closing, we pivot back to this side of the pond. This evolving empirical literature suggests, at least to us, that the SEC should be open to increasing transparency surrounding soft dollar payments in U.S. markets even if it is not prepared to support full adoption of a MiFID II-style regime. On balance, the empirical research shows that the unbundling of commissions has improved market efficiency by eliminating redundancy and producing information that is of great value to investors.

The complete paper is available for download here.

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One Comment

  1. Angela Paulk
    Posted Tuesday, October 27, 2020 at 7:11 am | Permalink

    As a former analyst on a top ranked US industrials equity research team, I agree with the article suggesting that one of the outcomes of MIFIDII has been a weeding out of quantity to get to quality. However, having led the MiFIDII programme for a large bank in the EU – and in challenging equity markets – I think a lot focus has been on not only transparency in pricing, but what can be marketed best i.e. stock/sector popularity & themes ‘ESG’. This business case lens doesn’t consider the nuance of cyclicality. I think part of research – and breadth of consistent coverage – is a long-term intelligence build which might be likened to R&D line item. Additionally, I think there is the unintended consequence of consolidation that needs to be considered – both on the sell-side and the buy-side… So, while I appreciate part of the commentary, not sure I fully agree as still not clear whether the longer-term implications of the regulation re valuations and market intelligence are actually improving…