U.S. institutional investors reduced soft-dollar expenditures by 10% from 2004 to 2005, but deeper cuts are being put off until regulators finally rule on the issue, according to a new report from consulting firm Greenwich Associates.

The report shows that soft-dollar commissions used by institutional investors to purchase third-party research and services fell to an estimated US$1.13 billion in the first quarter of 2005 from US$1.25 billion in Q1 2004.

While this represents a slide in soft-dollar usage, it’s not nearly as dramatic as investors predicted last year. In 2004, U.S. institutions told Greenwich that the combined amount spent on soft-dollar transactions and commission recapture arrangements would account for only 11% of their total U.S. equity commissions by 2005. Instead, soft dollars alone accounted for 10% of commissions, and when commission recapture is added, the combined amount represented approximately 17% of total U.S. equity commissions paid to brokers during the 12-month period.

“U.S. institutions are clearly adopting a more conservative approach when it comes to paying for brokerage research and services with soft dollars,” says Greenwich consultant Jay Bennett. “However, since the Securities and Exchange Commission’s review has taken longer than many investors had anticipated, the majority of U.S. institutions in the last 12 months have decided to await the regulator’s final word before making any further changes to their own business practices.”

Despite indications from the SEC that a soft-dollar ban is not in the works, the proportion of institutional investors using soft dollars continues to decline, Greenwich notes. It says that less than three-quarters of U.S. institutions reported using soft dollars over the past 12 months, down from 82% last year, and 86% in 2003.

It also notes that rather than stopping soft dollars completely, many firms are tightening internal rules about what they will and won’t pay for using soft dollars. As Greenwich consultant John Colon explains, “While certain institutions have stopped soft dollars completely, many of the companies that have taken strong stands with regard to their own soft-dollar policies have explicitly excluded soft-dollar payments for market data services, including price quotes, data terminals, and others — but have not cut out soft dollars for third-party research providers.”

U.S. institutions appear to be holding off on making major changes in their business practices until receiving final word on the SEC’s revised rules, the firm adds. While this leaves the issue open to individual firms’ interpretation, Greenwich suggests that a consensus is emerging around what should count for soft dollars. Included in this group are financial market quotes (such as Reuters and Bloomberg), which are paid for with soft dollars by more than 80% of U.S. institutions. Also in this category are third-party research produced by vendors and non-broker dealers, and financial databases – both of which are purchased with soft dollars by more than three-quarters of investors – and third-party research produced by “independent” boutiques, which is paid for with soft dollars by nearly 70% of U.S. institutional investors.

Currently, about 60% of U.S. institutions also use soft dollars to pay for electronic news and information services. However, the future of these soft-dollar arrangements appears less certain than that of some other services, Greenwich suggests.

“The emerging standard of eligibility for soft-dollar payment seems to be that the service must provide some value-added analytical or intellectual content,” says Colon. “This test can be difficult to apply to electronic systems that provide a wide range of market data, news, and other services. For now, institutions and brokers will have to evaluate for themselves whether a given service is simply a raw data stream — which apparently would not qualify as ‘research’ under this definition — or a source of some analytical content. The fact that 36% of the market is paying for electronic news and information services with hard dollars, suggests that some forms of news and information services are in doubt in terms of their appropriateness for soft-dollar payments.”

Across the board, more institutions are opting to pay hard dollars for services whose classification as research is less than clear cut. For example, only 20% of institutions pay soft dollars for news subscriptions and publications, which are purchased with hard dollars by more than 55% of institutions.

“Our study shows that hard-dollar payments for research remain unpopular with U.S. institutional investors, who would much prefer to preserve a system in which research is provided by the sell-side in exchange for commission business,” says Bennett. “These institutions should be encouraged by signals suggesting that the SEC is not seeking a soft-dollar ban. However, senior management at these investment organizations should be prepared to justify current soft-dollar expenditures in an environment of increasing transparency and stricter rules governing disclosure and breakdown of costs for trade execution and research.”