Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

VI. A New Framework: the EBEX Indicators

The answer to this question can be split into four important elements: •  The time at which the order is handed over (release time) to an intermediary (a broker, a trader or an algorithm) is the first point of reference, while the time at which the order is entirely filled (execution time of the last lot referring to the order in the event of splitting) is the second point of reference. The third and final point of reference is the next market close if the intermediary has discretion over the day to execute the trade or, in the event of specific instructions from the investor, the time at which the intermediary must stop trading. •  The size of “competing trades” is not important as such; the relevant measure is how many times a volume comparable to the order has been executed at a better price, which is a first measure of the quality of the price obtained. The price must be compared to small trades executed at better prices (the broker, trader, or algorithm could have split the order better) as well as with larger trades (the order could have been grouped with a larger flow of orders to be executed in block if such trading capability is offered). This important point makes our approach different from the RPM, which is built on a combination of both the number of trades and volume. •  Volumes traded before at a better price allow one to assess whether the broker, trader or algorithm has been too patient. •  Volumes traded after at a better price allow one to assess whether the broker, trader or algorithm has been too aggressive. EBEX relies on the elements above to measure the quality of execution as part of a peer group review and to identify whether the broker, trader or algorithm has implemented the execution too aggressively or too slowly.

This approach is built on two indicators. The Absolute EBEX indicator measures the quality of execution in a peer group review. The Directional EBEX indicator identifies whether the broker, trader or algorithm has implemented the execution too slowly or too aggressively. In other words, the first indicator assesses the quality of execution itself while the second indicator brings information about why the quality of execution is as observed. At this stage, we can identify similarities as well as differences between the EBEX framework and the RPM. Both involve peer group review and compare the average execution price of the trade to all contemporaneous market activity. Although they have the same philosophy, the EBEX framework makes it possible to gain quick insight not only into the final trading performance (the absolute EBEX indicator) but also into the possible justification of the performance (the directional EBEX indicator), thereby providing a direct measure of the quality of the market timing. This point is very relevant, as we know that pre-trade analysis should help intermediaries predict likely market conditions and define an appropriate trading strategy when they have discretion over how they fill the order. Getting the best price in the market may not always be a realistic objective, but execution at fair market prices certainly is. What is relevant for an investor then is to know where, with respect to the industry average, the orders executed by his intermediary fall.

69 An EDHEC Risk and Asset Management Research Centre Publication