Funny money

The U.S. capital markets, we are often told, are the deepest and most vibrant in the world. True. But that's no reason bankers, traders, legislators and regulators should not strive to make them even better. Over the past few years, in response to one scandal after another, reforms have been undertaken in everything from corporate accounting to securities research. One area that has avoided reform but which represents, arguably, Wall Street's most fundamental conflict of interest is the use by money managers of their customers' commissions to pay for goods and services other than trade execution.

This practice, known as "soft dollars," has been around for decades since it was devised by Bill Donaldson, co-founder of Donaldson, Lufkin & Jenrette and former chairman of the Securities and Exchange Commission. The idea was simple and clever: He reasoned that established money managers might be more willing to give the fledgling research boutique a chance if they didn't have to pay cash for its reports. Soft dollars have since been used to pay not only for research and data feeds but also for office furniture and more. Now even Donaldson, who left the SEC in July, thinks the market has changed sufficiently that the use of soft dollars should be reexamined, as he tells Senior Editor Justin Schack in "Sins of Commissions," beginning on page 36.

Others, like Marvin Mann, chairman of the independent trustees of Fidelity Funds, think policymakers should eliminate soft dollars entirely. Why? Because, as Schack shows, they hurt investors: One estimate puts the damage at about $33 billion annually -- far more than the cost of the market-timing and late-trading scandals at mutual funds.

"There's plenty of evidence showing that soft dollars are harmful to investors," says Schack, who most recently wrote about the failures of the $1.5 billion Wall Street research analyst settlement, in our October issue. "But because they're so complex, few realize how damaging they are. And because they're so vital to Wall Street profits, those with the power to ban soft dollars have nothing to gain from doing so."

Some defenders of soft dollars argue that because they are so entrenched in the financial system, eliminating them could harm the capital markets. More likely, say critics, doing so would make the markets far friendlier to investors.