Many of us who live in a world characterised by liberalised economies take deregulated economic systems for granted. But things were not always that way, even in the advanced economies.
For instance, until 1975 in the US, 1987 in the UK, and 1999 in Japan, the law stipulated a minimum brokerage fee that brokers had to charge their clients. This was irrespective of the volume of business generated by a client. Institutional clients were paying more than what they should have, while retail clients were paying less than what they ought to have paid. In other words, there was a cross-subsidy.
Even in a haven of free enterprise like Hong Kong, there was a minimum stipulated brokerage until 2003. When brokerage was deregulated, initially retail clients experienced a sharp increase in the rates paid by them. But deregulation led to the birth of a brand new category of institutions, known as discount brokerage houses. These brokers did not provide any research inputs or any other items of value. They competed solely on the basis of price. There exists, in fact, a category of brokers known as deep-discount brokers who charge even less than the discount brokers. However, such brokers require order sizes of relatively large magnitudes.
In today?s deregulated economy, we have three categories of brokers. Full-service brokers continue to charge relatively higher brokerage rates, but they offer items of perceived value to their clients. It must be pointed out that the brokerage rates advertised by such brokers are akin to the rack rates at 5-star hotels. Most regular clients can negotiate better terms and, consequently, pay less.
In a deregulated industry, brokers can obviously compete on the basis of price. Since this option was ruled out earlier, they had to use other methods in order to compete, and this took the form of freebies offered to the clients.
It was and is a common practice for brokers in the West to offer things of value gratis to their clients. Some brokers distinguished themselves on the basis of the quantity and quality of their research reports. Many chose to give away items of value like accounting systems, communications systems, and computing systems. It was not unknown to have brokers train the staff of their leading institutional clients on the finer aspects of trading and the securities industry and the freebies could, at times, be exotic.
It was realised at some stage that a system of accounting was required to ensure that the freebies being provided were commensurate with the volume of business generated by the client. To facilitate this process, a system of Soft Dollar Accounting was created. This is similar to the point system used by credit card issuers. That is, for every rupee spent by a cardholder, he is credited with a number of points, and such points can be accumulated and periodically redeemed to acquire items of value.
In the context of brokerage, a client was credited with a certain number of notional or soft dollars for every actual or hard dollar spent. These soft dollars could be accumulated and used subsequently to obtain items of value. This system allowed brokers to compete despite the floor on commissions. More aggressive brokers gave away more soft dollars per hard dollar spent. This effectively made a mockery of the minimum brokerage concept, and is believed to be one of the reasons behind the deregulation of the brokerage industry.
When deregulation occurred, many analysts thought that the soft dollar system would be dismantled. On the contrary, the use of soft dollars has increased after deregulation, and there are clients who voluntarily agree to pay higher commissions in order to earn more soft dollars.
The reason for this phenomenon is very interesting. If a mutual fund were to pay directly for services rendered, in the form of expenses other than trading commissions, it would show up in the form of a higher expense ratio. Thus, there are fund managers who choose to pay for services provided by brokerage firms, in the form of higher commissions. This leads to a situation where the brokers charge a higher fee, leading to a greater outflow when a fund acquires securities and a smaller inflow when it redeems securities.
However, the cost of other services provided by the brokerage firm does not appear as a component of the fund?s expense ratio. By using this technique, fund managers can create an illusion of efficiency.
Investors should remember that the use of soft dollars will not manifest itself in the form of a higher net asset value. This is because funds are flowing out of the mutual fund to the brokerage house, whether they are in the form of direct expenses for services received, or in the form of higher brokerage costs. Thus, the perceived efficiency is illusory and not real.
The writer is the author of Fundamentals of Financial Instruments, published by Wiley India
