Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

Introduction

From retail to more professional investors and practitioners, all are concerned with transaction costs, as it is an established fact that lower transaction costs automatically enable higher returns. To provide their clients with competitive portfolio returns, investment firms need to be proactive and put in place the appropriate means of effective transaction cost management. However, when implementing their client decisions, investment managers often cope with issues regarding how transaction costs can be properly identified, measured, forecasted as well as how the quality of execution should be evaluated. Most of the time, these fundamental questions remain open because relatively little information is directly available. In some cases, facing the multiple commercial tools that are offered, investment managers choose and apply the most popular indicators in the industry, without really knowing if they provide useful and meaningful answers to their initial concerns. Some even admit that they are sometimes confused, especially when they are offered tools based on sophisticated models resembling “black boxes”. Transaction costs are becoming both a topical and relevant issue in Europe with MiFID—the Markets in Financial Instruments Directive 1 —now in place. In the near future, the role of transaction cost analysis (TCA) is expected to grow substantially as a result of the best execution obligation. According to this new obligation, investment firms must “take all reasonable steps to obtain the best possible result when executing orders for their clients”. Although so far a mix of both principle- and rule-based regulation, this new obligation is a key element for

investor protection in a marketplace that is completely open to competition.

Best execution has consequently become a very fashionable concept. Nevertheless, because the regulator has brought neither a clear definition nor a measurable objective to make up for the current absence of consensus, this concept is not always well understood and does not mean the same thing to everyone. We can easily find evidence of this phenomenon by simply reviewing the press and the multiple occasions where liquidity providers, MTFs, 2 platforms, and technology vendors claim to provide “best execution”, even though there is as yet no consensus on what exactly “best execution” entails or, more importantly, while some of those platforms are not yet operational. This ongoing and widespread confusion around best execution—and, to a larger extent, around TCA as a whole—is likely to have serious side effects such as increased moral hazard, greater adverse selection and a false sense of security given to end clients. These consequences tend to emerge when a piece of regulation attempts to legislate on elements that may not be factually demonstrated. To clear up the above-mentioned confusion, we cover in the present work a broad range of material related to TCA and best execution. As understanding transaction costs is crucial to properly assessing the quality of implementation decisions and complying with the best execution obligation in the post-MiFID environment, our objectives are the following: •  provide a state of the art of TCA fundamentals; •  do a critical review of existing post-trade TCA techniques;

1 - MiFID is the second step in the harmonisation of the European capital markets industry and aims to adapt the first Investment Services Directive (ISD 1, issued in 1993) to the realities of the current market structure. Part of the European Financial Services Plan (FSAP), the “MiFID” (Directive 2004/39/ EC, formerly known as Investment Services Directive II) was ratified by the European Parliament on April 21st, 2004. The implementing Directive and Regulation were approved by the Parliament over the summer of 2006 and provide detailed implementation guidelines applicable to all member states. MiFID came into force in November 2007. In a nutshell, MiFID sweeps away the very concept of central exchange and obligation of order concentration currently existing in several European countries, and recognises the need to include all participants in the execution cycle and all financial instruments under a consistent regulatory framework. At the same time, MiFID offsets the opening of the execution landscape to full competition with a set of obligations whose goal is to increase transparency and investor protection in order to maintain the efficient and fair price discovery mechanisms as well as the overall integrity of European markets in the face of inevitable fragmentation. 2 - MTF: multilateral trading facility

6 An EDHEC Risk and Asset Management Research Centre Publication