Securities regulators declined Wednesday to make it illegal for brokerages to include the cost of stock and bond research in their fees for trading execution.The Securities and Exchange Commission voted 5-0 to outlaw the most glaring abuses of so-called "soft-dollar" arrangements, which include the exchange of computer hardware for trading business. But the agency stopped short of enacting reforms sought by some large money managers, who wanted a hard separation of research and trading fees -- a practice known as unbundling. The SEC's 5-0 vote, while approving clearer guidelines for what constitutes legitimate soft-dollar payments, implicitly stated that it's OK for Wall Street brokerage to include research costs into trading fee. The commission commended some recent moves on Wall Street to unbundle, or disengage research and trading costs. But the SEC was unwilling to make unbundling mandatory, something that's sure to disappoint investor advocates who see soft dollars as an additional charge on trades. "It's a lot of bark, but not a lot of bite," said David Easthope, consultant at research firm Celent. "There is not much to the new rule; it really just adopts what the industry is already doing. Essentially, it is a system where soft dollars are still legal, under these new standards. It is basically business as usual." The issue of restricting soft-dollar practices, extra payments that are imbedded in the trading fees charged by Wall Street brokerages, has plagued Wall Street for some time now. Large money managers, such as Fidelity, contend soft-dollar arrangements, in many instances, increase their trading costs, something that hurts retail investors. But the securities industry appears to be moving faster and more courageously than the regulators. A number of prominent money managers are demanding that brokerages separate the cost of paying for stock research from the commission they pay. While Fidelity is the only firm that has admitted to its agreement with Lehman, a number of other firms are rumored to have similar agreements. Some brokerages are finding that this process of unbundling may make sense and doesn't necessarily mean a loss of revenue.
On the brokerage side, Lehman Brothers ( LEH) has been the prime mover in reshaping the way it charges clients for research and trading. Last November, Lehman cut a deal with Fidelity Investments to charge separately for trading and research, making it the first U.S. firm to agree to an unbundled program. The deal with the mutual fund giant resulted in an instant cost savings for Fidelity. But surprisingly, the arrangement also is paying dividends for Lehman in terms of increased trading activity by Fidelity, say people close to the Wall Street investment firm. Lehman executives, during the firm's most recent earnings call, attributed big gains in equity trading for propelling the firm's second-quarter earnings up 47%. Equity capital markets, which includes equity-trading revenue, rose 85%, and the division is slowly catching up to the fixed income group -- a staple business for Lehman. Recently, a Lehman Brothers employee, who did not want to be identified, offered some insight into the firm's strategy. "Some pay for principle trading, others for simple execution. Lehman goes client by client and asks them why they are paying the Street," says the employee. "It's like running a candy store. You figure out why they are coming to the candy store, and you offer them more of it." Internally, the firm is taking every step it can to quantify how Wall Street pays its trading and research business. In a move to give special treatment to the top paying clients, the firm cut back its printed research reports and put some of its analysts on the trading floor. These analysts are instructed to serve only clients that pay for special treatment. Fidelity, for example, wouldn't be privy to Lehman's stock specialists unless they were willing to cut a bigger check to Lehman for the research part of its services.
On Wednesday the SEC commended Lehman for its unbundling practices, and said that the regulators would consider pushing unbundling for all firms. The SEC's job is to provide clarity for the markets, the SEC said, and the Fidelity/Lehman partnership provides clarity for their clients. Still, some insiders are wondering if unbundling is really good for Wall Street. "The SEC is attempting to make this a more healthy marketplace, and they believe they are being amenable to third-party providers," Easthope says. "But this ruling is still just amenable to order flow." Smaller research shops will suffer, says Easthope. In fact two firms, Thomas Weisel ( TWPG) and Cowen, recently said unbundling practices were a significant risk to their business. Other insiders are also concerned that Lehman's plans to cut research can lead to so-called "selective disclosure," or giving certain high-paying clients information while withholding the information from others. But while Wall Street's researchers lose sleep over the best way to charge for their services, the SEC remains a bystander. "It had been a while since anyone heard from the SEC about this topic, so it's good to get something," says Easthope. "But the 5-0 ruling also proves that it's not very controversial."