Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

as well as by back-office intermediaries such as custodian banks.

financial institutions may not benefit from the advanced and proven market infrastructure that makes it possible to streamline and automate transactions. As a result, in the post-MiFID environment, financial institutions must address the consequences of choosing alternative trading venues not only in relation to the execution process but, more importantly, in light of the impact on the entire trade processing cycle as well. The choice of alternative platforms implying OTC transactions ( e.g. , dark liquidity pools) might present significant advantages in terms of execution efficiency and quality but is likely to impose operational constraints that need to be addressed to avoid possibly significant capital implications. Likewise, the extent to which operations are outsourced is likely to modify the firm’s overall operational risk profile. Basel II does not allow firms to eliminate capital requirements by transferring operations to third-party providers, but those third parties may boast more modern and scalable operations tailored to processing transactions in the most efficient manner, implicitly reducing operational risks. When a firm outsources its transaction processing cycle to a third party, it is usually to a partner that specialises in providing this service; the firm can thus benefit from economies of scale and gain access to state-of-the-art infrastructure. The quest for operations efficiency and the associated reduction in operational- risk costs account for much of the recent success of outsourcing offerings developed by pure back-office providers

So it would be a mistake to believe that the choice of execution venue or changes in execution methods have no implications on the back-end of the processing cycle. Custodian banks have understood the importance of post- trade processing in the search for best execution perfectly well and, through better integration of alternative trading cycles in their operational processes with the aim of both reducing operational constraints and risks and enhancing overall efficiency, are well positioned to support the new requirements created by the fragmentation of liquidity venues. Counterparty risk exists when a financial institution transacts with another firm that may default on its obligation to settle a transaction or deliver securities related to a transaction. This situation can arise when the counterparty is in financial distress (we are then confronted with credit risk) or when the counterparty faces a pure operational or cash management/ stock management glitch. As a consequence, counterparty risk can occur when a financial institution lends cash or securities, but it could also be influenced by occasional problems in the settlement cycle. Failure to collect payment or deliver securities can have a damaging impact on a financial institution, as it may cause the firm to default on other transactions and create a cascade of events that can, if not dealt with in due time, lead to default. 2.b Indirect costs related to counterparty (and credit) risks

17 An EDHEC Risk and Asset Management Research Centre Publication