Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

have huge consequences on the economic profitability of trading activity.

We will not deal here with the question of credit risk, i.e ., the assessment of the ability of the firm’s counterparties to meet their obligation to repay/deliver, as this element is part of normal banking activity. The risk incurred by firms as a result of the settlement process of transactions should nonetheless be taken extremely seriously in light of the changes resulting from the implementation of MiFID. The direct consequence of the development of MTFs and systematic internalisation is the likely significant increase in OTC transactions that involve a direct settlement to the counterparty of the traderatherthantheclearingoftransactions through a clearing house and a central counterparty. In most established markets, central counterparties and clearing houses have made it possible to reduce the complexity of the settlement process significantly (thanks to the netting of transactions) as well as the counterparty risk (thanks to the use of a single central counterparty managing the individual counterparty risks through appropriate processes such as delivery versus payment). Once again, the choice of venue and the selection of a mode of execution will have a direct impact on the final level of risks and costs incurred by the financial institution.

So, to benefit from the economies of scale and state-of-the-art infrastructure offered by firms specialising in post-trade processing, financial institutions have begun outsourcing part of their back- office responsibilities to third parties. Three broad benefits are to be expected: • A decrease in the investments required to cover a growing number of liquidity pools with regards to post-trade processing. As specialist firms build infrastructure centrally for a large number of clients, they indirectly let their clients benefit from economies of scale that allow them to cover a larger number of pools than individual financial institutions would otherwise be able to. • A significant increase in processing efficiency, leading to better control of explicit direct costs (settlement costs, costs of handling the clearing process, costs of reporting, streamlined processes for managing mistakes) • A significant decrease in operational risk and application of the most advanced management processes, making it possible to reduce counterparty risk (or at the very least improve the management of breaks and intraday defaults) and the capital set aside as part of the Basel II framework. But third-party back-office providers and custodians have also realised that their status as recipients of transaction data puts them in an ideal position to develop and propose a set of value-add services directly related to transaction cost analysis. Much as with the development of risk and performance allocation services

2.d Increased importance of back-office providers

Allocatingtheexact indirect explicit costsof operational and counterparty risks to single transactions is obviously too ambitious, but these costs do represent significant expenditures or capital requirements that

18

An EDHEC Risk and Asset Management Research Centre Publication