Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

Capital requirements related to these costs are currently assessed on a global basis; allocating these costs to specific trading activities remains very ambitious even though these costs are often estimated to support strategic organisational decisions. Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. From the perspective of managing transactions in financial instruments, operational risks relate to the risk of loss resulting from inadequate or failed internal processes, people and systems in the handling of the transaction cycle. The definition provided in the Basel II capital requirement framework encom- passes situations such as: •  Internal fraud—misappropriation of assets, tax evasion, intentional mismarking of positions •  External fraud—theft of information, hacking damage, third-party theft and forgery •  Business disruption and systems failures—utility disruptions, software failures, hardware failures •  Execution, delivery, and process managemen t—da t a - en t r y e r ro r s , accounting errors, failed mandatory reporting, negligent loss of client assets. The complex nature of the entire trade processing cycle, from execution to settlement, therefore has a direct impact on the operational risks borne by the financial institution. 2.a Indirect costs related to operational risks

Taxes/stamp duties are visible and variable transaction cost components. They are visible because tax rates or specific stamp duties are known in advance but variable because they often vary by type of return or trade. In theory, explicit costs could be determined before the execution of the trade. In practice, their measurement is not so obvious because brokerage commissions are often paid for bundled services, not only for order execution. Research, analytics and trading technology are often bundled services provided by intermediaries. A trend towards unbundling is being observed in Europe and the US. New unbundling of commission regulations, which separates the payment for deal execution and the payment for broker research, will surely facilitate the measurement of explicit costs. 2. Indirect Explicit Transaction Costs In addition to direct costs, explicit costs also include a number of indirect costs having todowiththeprocessingsupporting the execution and the counterparties involved. Even though the determination of these costs in today’s environment is very difficult (and perhaps impossible on a trade-by-trade basis), their importance should not be underestimated when venues or particular types of transaction are opted for. These indirect explicit transaction costs encompass: •  capital costs related to operational risks •  capital costs related to counterparty (and credit) risks

15 An EDHEC Risk and Asset Management Research Centre Publication

Made with FlippingBook flipbook maker