Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring Transaction Costs with Post-Trade Analysis

signed difference between the trade price and the average of the lowest, highest, opening and closing prices of the day. This indicator is widely recognised in the industry, even though it suffers from the same shortcomings as VWAP indicators. Furthermore, as a simple average of prices irrespective of traded quantities, the LHOC is less representative of the fair market price since it misses the dimension of market depth included in the VWAP. Under pressure from MiFID, TCA is set to grow and transaction cost measurement in particular is likely to become both a widespread and a more than essential practice. However, two main issues are emerging with the new regulation and are expected to make transaction cost measurement more complex in the near future. The first has to do with market fragmentation and the second with data availability and processing. (1) Market fragmentation The European trading landscape is likely to become more fragmented 6 post- MiFID since the new regulation clearly encourages the proliferation of liquidity pools and promotes competition by putting an end to the well-established order concentration rule. This rule had hitherto made it possible for most of the traditional exchanges to maintain monopolistic positions and be viewed as official providers of reference prices in a great majority of European countries. By allowing multiple trading venues to compete, MiFID is, by design, allowing liquidity pools to fragment and put 4. Measuring Transaction Costs under MiFID

trading venues compute and publish daily VWAP in real time. However, the window can be shorter (interval/available VWAP) or longer than one day (multi-day VWAP). The VWAP-related indicator is widely used in the industry, mainly because it is easily interpreted: it indicates whether the trader received a higher or lower price than did the “average trader” of the measurement interval. Nevertheless, the VWAP benchmark is inappropriate for correct measurement of transaction costs. (c) Closing price benchmark The indicator based on the closing price is the signed difference between the trade price and the closing price of the day. This benchmark is very attractive in the industry because it is easy to get and requires little data processing. All other popular indicators require intraday market trade data (VWAP, LHOC) or quotation data (spread midpoint), while the indicator relying on the closing price needs only summary daily market data. Furthermore, many investment firms prefer to use closing prices as benchmarks because they already value their portfolios at these prices. Although attractive, the closing price may not provide an effective measure of implicit costs. It can only deliver indicators of temporary market impact, because permanent impact is incorporated into future prices. Moreover, such indicators are noisy when the time gap between the execution of the trade and the market close is long.

6 - Fragmentation occurs when not all orders relative to a given security interact with each other in a single execution system. Markets are fragmented when people can trade the same securities in various trading venues. Markets are consolidated when all market participants trade on the same execution venue. In practice, we obviously refer to fragmentation as soon as a given security is cross-listed or may be traded on multiple execution venues.

(d) Average of LHOC The indicator relying on the LHOC is the

35 An EDHEC Risk and Asset Management Research Centre Publication

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