Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

Understanding exactly what transaction costs are and why they arise is the first and fundamental step when dealing with TCA. Transaction costs have nine components, usually categorised as implicit or explicit, as shown in figure 1. In this section, we describe the components of both categories in detail and give insights into why these costs arise when implementing investment decisions.

Brokerage commissions are paid to intermediaries for executing trades. They can be expressed on a per share basis or based on a total transaction value, most of the time in basis points and subject to volume discount. Although they differ from one intermediary to another, they are a fixed and visible transaction cost component. Market fees are paid to trading venues for executing trades on their platforms. They are usually bundled into brokerage commissions for investors. These fees vary. On average, higher volume markets have the lowest costs. In recent years, competitive pressure has led to a significant reduction in these explicit costs. Like brokerage commissions, market fees are considered a fixed and visible transaction cost component. Clearing and settlement costs are related to the process whereby the ownership of securities is transferred finally and irrevocably from one investor to another. When the trading venue owns the clearing and settlement system, these costs, which are a fixed and visible transaction cost component, are usually included in market fees. Like the latter, clearing and settlement costs differ from one trading venue to another. This is illustrated in table 1, which exhibits statistics about the cost per execution (in € ) in the main European stock exchanges.

Figure 1: Typology of transaction costs

Brokerage Commissions Market Fees Clearing and Settlement Costs Taxes/Stamp Duties

Bid-Ask Spread Market Impact

Operational Opportunity Costs Market Timing Opportunity Costs Missed Trade Opportunity Costs _ Explicit Costs _

Implicit Costs

Those costs can be considered direct when related to individual orders/transactions, or indirect when accounted for globally as part of the provision of the transaction services. To provide a full picture, we also introduce the concept of direct and indirect explicit transaction costs. 1. Direct Explicit Transaction Costs Brokerage commissions, market fees, clearing and settlement costs, and taxes/ stamp duties are explicit costs. They are said to be explicit because they do not depend on the trade price and are usually documented separately from it. As these costs do not rely on the trading strategy, they can be known in advance, before the execution of the trade.

Table 1: Cost per execution in Europe ( € ) Cost per Execution

Mean Maximum Minimum

Exchange

2.85

4.94

1.57

Clearing

1.24

2.57

0.38

Settlement

1.22

2.18

0.52

Total cost

5.31

7.00

4.01

Source: Various public sources (2007)

14

An EDHEC Risk and Asset Management Research Centre Publication