The Impact of Soft Dollars on Market Equilibrium and Investors' Profits

Abstract

This paper examines the impact of soft dollar practices on market equilibrium and trading profits. The setting is one in which there exist both money managers and individual (nonclient) investors and in which soft dollar payments from brokers to money managers cannot be publicly observed. In this context it is shown that soft dollars increase the trading aggressiveness of money managers and decrease the aggressiveness of nonclient investors. Under certain conditions, the increased trading aggressiveness of the managers leads to an increase in their clients' expected profits, but to a decline in market liquidity and total trading volume. These results hold whether or not the clients adjust the money managers' fee for the expected soft dollar payments. However, if the actual amount of soft dollars paid were observable, their value to the client may disappear. The results of this paper should be of interest to the Securities and Exchange Commission, which is currently considering expanding the reporting requirements for soft dollars.