Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

5. Transaction Costs and Execution Methods

In principal trading, the broker provides the investor with guaranteed execution of the trade list at the market prices at a specific point in time (usually the close). Here, the entire market risk is transferred to the broker because he acquires the investor’s position and all associated risk. As a consequence, brokerage fees are higher than for agency trades and depend on the risk associated with the execution of the trade list. These specific higher commissions are known as the principal bid premium and serve as an insurance policy for the broker.

Transaction costs also depend on execution methods. There are two kinds of techniques for executing an order: agency trading or principal trading. The two methods differ in terms of the risk sharing between the investor and the executing broker. In fact, the choice between agency trades and principal trades involves a trade-off between a low certain explicit cost and an uncertain implicit cost. Agency trading is the most common execution method. When sending orders to the market through an agency, the investor bears all the risks associated with the trade. The agency assumes no market risk, so all the implicit costs fall on the investor. In practice, the investor sends an order to the broker, specifying the name of the security and the number of shares to buy or sell. The agency then executes the order and the speed of execution depends mainly on the order size and the available liquidity. In some cases, the investor can give the agency price (closing price, daily VWAP, etc.) or volume (percentage of the daily volume, for example) constraints. Average brokerage fees are relatively low.

The two methods and their implications are summarised in table 2.

Table 2: Execution methods and transaction costs

Execution method Characteristics

Advantage

Disadvantage

Agency trade

Release of an order specifying the security and the quantity Execution on the market with or without a target (closing price, VWAP, etc.) Determination of a basket: size, securities, etc. Commitment of the broker to trade the basket at a predetermined price

Low fees

Market risk (implicit costs)

Principal trade

No market risk Higher fees

25 An EDHEC Risk and Asset Management Research Centre Publication

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