Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

analysis of transaction costs is—because it is a prerequisite to the smooth running of a fragmented execution market—likely to become one of the essential value-added services provided by custodian banks to financial institutions managing third- party assets. 3. Implicit Transaction Costs Transaction costs are more than just brokerage commissions, market fees and taxes. Implicit costs are the transaction costs that, invisible, cannot be known in advance because they are included in the trade price. They depend mainly on the trade characteristics relative to the prevailing market conditions. In other words, they are strongly related to the trading strategy and, as variable costs, provide opportunities to improve the quality of execution. These implicit costs can be broken down into their components: spread, market impact and opportunity costs . (1) Spread This component is compensation for the costs incurred by the liquidity provider. When taking liquidity (by buying at the best ask or selling at the best bid), we pay the spread. In the microstructure literature, three kinds of cost are usually associated with the bid-ask spread. The order processing cost is compensation for supplying an immediacy service to the market (Demsetz 1968). The ability to trade immediately rather than to have to wait for the opposite trade provides certainty for market participants. Liquidity is thus provided at that cost.

delivered by back-office providers on the basis of portfolio and transaction data collected to manage positions on behalf of clients, these intermediaries can now offer transaction cost analysis services based on transaction data transmitted for settlement purposes. The firms that attempt to provide services for the monitoring of best execution will face two main challenges: • Access to data and consolidation of external market tick and transaction data •  Enrichment of existing front-to-back data flows to include front-office trading information (timestamps) The second challenge is under the control of the third-party provider (though we do not underestimate the operational and technical complexity of handling trade data in addition to data usually transmitted for settlement and reporting purpose only), but creating an adequate repository of market and transaction data that will make it possible to perform such advanced forms of transaction cost analysis as peer group analysis will require heavy investment and proper coordination throughout the industry, as MiFID failed to deliver an industry model that would simplify the collection and re-distribution of public information on markets and transactions. All the same, it is clear that back- office intermediaries are the only firms currently involved in the transaction cycle in a position to offer an independent assessment of transaction costs on behalf of the final investor. Like independent asset valuation, likely to be in demand following the recent banking crisis, independent

19 An EDHEC Risk and Asset Management Research Centre Publication