Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring transaction costs with post-trade analysis

given security. It is then necessary to pay attention to the venue(s) the order is routed to. When an order is routed to and entirely executed on a single trading venue (for whatever reason 10 ), it seems quite consistent to use as benchmarks prices available on that venue. But when an order is split into smaller lots that are routed to several execution venues to sweep the market by taking liquidity from all sources at once—as may be frequent for large orders—complications arise and measuring transaction costs becomes a true brain-teaser. When there are multiple price sources for an order, the ability to keep track of and consolidate all these prices is eventually the major determinant of the ability to measure costs properly. Theoretically, each lot should be considered a single order for which transaction costs could be measured based on benchmarks prevailing on its execution venue. Next, the total cost of trading for the initial order should be obtained by adding all costs related to each lot. This approach requires great data storage and processing capabilities. (2) Data availability and treatment Accurate transaction cost measurement requires a large amount of time-stamped data about orders and trades. Besides, as we have just mentioned, post-MiFID market fragmentation is likely to tighten these requirements substantially. In practice, investment firms can have trouble collecting information about their own trades as well as collecting market data. The reason is twofold: •  Incompleteness of internal databases Time-stamped information on individual

the very existence of an acknowledged reference price at risk. At first sight, both benchmark comparison and implementation shortfall are made conceptually difficult in the absence of an acknowledged unique price for the securities traded. When a security is traded at the same time on various execution venues, which of the coexisting prices is the best reference for the security? Several elements can be put forward to address this point. Under MiFID, investment firms have potential access to a wide range of execution venues in the form of regulated markets, 7 MTFs 8 and systematic internalisers. 9 However, as part of the best execution obligation, MiFID requires that investment firms determine their own unique set of execution venues and define an execution policy documenting the selected trading venues as well as the factors that led to this selection. This selection process reduces the number of liquidity pools to consider when executing orders and creates a “frame of reference” within which each firm must meet its best execution obligation. Hence, when it comes to measuring transaction costs, only the list of selected execution venues will be relevant to determine reference prices. When only one trading venue is selected for a given security, we are back to a pre- MiFID situation with a single recognised reference price; therefore, transaction costs can be measured as simply as previously described. However, this case is likely to be an exception and, most of the time it is likely that more than one trading venue has been selected for a

7 - This regime refers to the traditional exchanges in the MiFID language.

8 - Multilateral trading facilities are similar to

regulated exchanges in that they allow clients to enter into negotiations without taking part in a transaction as counterparty. They include all forms of multilateral negotiations such as order books, block trades, periodic auctions and any other mechanism resulting in negotiations between two counterparties. 9 - This new regime allows investment firms on an organised, frequent and systematic basis to deal on their own account by executing client orders outside a regulated market or MTF. 10 - This can be a constraint set by the client, an automated choice when the venue quotes the best of the prices available, etc.

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An EDHEC Risk and Asset Management Research Centre Publication