Institutional investors sharply cut back on their use of soft dollars last year, but they are starting to relent on that, according to new research from Greenwich Associates.

Greenwich Associates suggests that institutions are starting to return to business as usual when it comes to paying third-party brokers for research and other services based on a growing belief that the Securities and Exchange Commissions is not planning a dramatic overhaul of rules in this area.

For the past several years, uncertainty about how regulators would ultimately rule on the issue of soft-dollar arrangements has prompted U.S. institutions to adopt a conservative stance in their use of client commissions to pay for third-party broker research and services, it notes. Due in large part to this uncertainty, industry-wide soft dollar totals dropped 25% to $725 million in the 12-month period ending in February 2007 from US$970 million the prior year.

As recently as 2004, more than 80% of institutions used soft dollars; by 2007 that proportion had fallen to 62%. In keeping with the general decline in usage, commissions directed for third-party products and services have dwindled as a proportion of overall U.S. equity commission payments, which totaled US$10.3 billion in the year ending February 2007, Greenwich said. Payments for third-party research products and services represented 9% of total commission payments in 2005 and 2006, but only 7% this year.

Greenwich Associates research reveals a sharp turn in sentiment, however, as the SEC has provided guidance about what it considers appropriate with regard to third-party payment.

When asked to project their intended third-party products/services budgets for the coming year, institutions predict a market-wide bounce back to 10% of total commissions. Investment managers predict that third-party allocations will jump to 13% in 2008, and banks expect to increase allocations slightly from the current 20%.

The research also uncovers another sign that institutions are becoming more comfortable with the regulatory environment: roughly 30% have set up client commission-sharing arrangements with brokers, and 60% say they will have one in place within the next 12 months, the firm reports. “Two-thirds of the market’s largest institutions and most active traders expect to have a CCA in place by year-end 2007,” says Greenwich Associates consultant John Colon.

Institutions in the Greenwich sample spent a reported US$445 million in hard dollars on equity research for the 12 months ending February 2007, up from about US$260 million a year ago, with most of those amounts coming from investment managers and hedge funds. Even amid this strong growth, however, the actual number of institutions using hard dollars to purchase equity research and services slightly declined. “Less than a third of U.S. institutions are currently buying equity research and services with hard dollars, off slightly from 35% last year,” says Greenwich Associates consultant Jay Bennett. “That decline represents a reversal: from 2005 to 2006 the proportion of institutions using hard dollars climbed from 29% to 35%.”

In July 2006 the SEC announced new rules clarifying the types of research content and services that can be paid for with client commissions — an action that Greenwich says appears to be having an impact on institutions’ hard-dollar spending for specific content and services. In particular, 40% of institutions use hard dollars to pay for equity research from vendors or non-broker dealers and 32% use hard dollars for research from “independent” brokers. “Both items unambiguously fall within the safe harbor as defined by the SEC last year,” says Greenwich Associates consultant John Feng.

One of regulator’s stated goals has been to strengthen the independence of brokerage equity research by encouraging the use of research from independent and third-party providers. Over the past 12 months, however, the proportion of commission payments for third-party products and services directed to independent brokers and non-broker dealers dipped to just over a quarter from slightly more than a third, Greenwich reported.