Date Posted: April 2008
This paper relies on the economics of transaction costs to assess the likely effect on investor welfare of the U.S. Securities and Exchange Commission’s (SEC’s) prohibition on an innovative business practice known as directed brokerage. Its key insight is that the quality of a broker’s execution of portfolio trades is difficult for a mutual fund adviser to assess until it is too late ? that is, execution quality is an “experience good.” In the meantime, low-quality brokerage can substantially reduce investor returns. To have the incentive to provide high-quality execution, a broker must expect to receive a stream of premium portfolio commissions in excess of his execution costs, much along the lines of a Klein-Leffler quality-assuring price premium. Competition between brokers for premium commissions leads them to post a performance bond with advisers equal to the present value of the expected premium stream. With directed brokerage, the bond takes the form of up-front broker effort devoted to marketing the fund’s retail shares. Once having posted the bond, any broker that provides low-quality execution will eventually be terminated by the adviser and lose the premium stream that provides a normal return on the up-front bond. Low-quality brokerage is thus screened out. Contrary to its intended effect, the SEC’s prohibition on directed brokerage likely reduces investor welfare by failing to recognize the problems inherent in transacting experience goods.