From Best Ex to Coaching:The Future of Transaction Cost Research

In a trading environment with multiple execution venues, high-speed transaction rates, intense competition and regulatory scrutiny, transaction cost measurement systems are a virtual requirement for investment managers. Buy-side firms are looking to gain competitive advantage to gather more assets under management, increase returns and streamline regulatory processes. At the same time, buy-side traders are executing more of their orders without the help of sales-traders and need detailed information on what strategies are and are not working. Transaction cost research (TCR) tools have become ubiquitous precisely because they are used to achieve key objectives such as client retention, capital introduction and proof of fiduciary adherence.

The multi-purpose nature of TCR has led to market segmentation and created a “feature sprawl”, as different vendors have focused on fulfilling certain demands, highlighting the market’s segmentation. Historically, the client segmentations and subsequent product niches make sense. Pension plans do not want or need the same level of detail as an investment manager or broker-dealer. However, investment managers increasingly want to see what their pensions plans see, in addition to more detailed and timely information. Meanwhile, broker-dealers are receiving third party TCR reports for marketing purposes—proving best execution helps attract order flow. It is only a matter of time before a TCR provider figures out a way to satisfy all of these requirements on one platform. It is ironic thought that a practice created to help traders deal with fragmented liquidity, is itself fragmented.

TCR firms are working on a number of client-driven enhancements. Measurement tools will be embedded into other trading components, most notably the Order Management System. Customizable views and multiple metrics will make TCR more user-friendly and useful. An increased reliance on measuring transaction costs is also driving demand for faster delivery, including real-time analytics. Finally, pre-trade cost analytics will bring the process full circle by helping firms prevent mistakes instead of just identifying them.

Measuring something as complicated and transitory as the equity markets may be leading to some unintended consequences; in particular the growth of electronic execution tools. When pension plans and their trustees began measuring the transaction costs of their investment managers, they had no way of predicting that it would contribute to the dominance of algorithms and other advanced electronic execution tools. However, in order to compare investment managers to one another, there needs to be a consistent measurement, such as VWAP. As a result, investment managers have begun to funnel a phenomenal amount of order flow through trading modules designed to achieve VWAP and other benchmarks. The result is that liquidity has been broken into bite-sized segments. Not all of this can be put on the doorstep of TCR, but ask any trader if VWAP is used because that is how the order will be judged and it becomes clear that it is partially responsible.

The relationship of trading behavior and the measurement of transaction costs is a two-way street. Today, Volume Weighted Average Price (VWAP) is the standard for comparing one firm to another, and hence, the most popular metric. In fact, the use of VWAP to measure transaction costs may be a primary driver of the increased use of VWAP algorithms. However, competitive drive often pushes firms to swing for the fences, while VWAP breeds mediocrity. Accordingly, as buy-side institutions strive to improve upon VWAP, transaction cost research will play a critical role in this shift by highlighting the relationship between the benchmarks and enabling more effective electronic executions.

Meanwhile, buy-side firms are still determining the most effective method to embed transaction cost research into the trading process. No one wants mire traders in “analysis paralysis”. To what degree can a trader be held responsible for a bad trade? How is the trade difficulty measured? All of these issues are just natural products of this new way of looking at how we trade and will help define the future value of TCR and how it is woven into the traders’ decision-making process.

In the end, transaction cost research will be absorbed into the trading process, instead of standing outside of it. Pension plans and clients will continue to receive large reports, but on the trading desk TCR will become as familiar and inseparable from the trading process as any other piece of market data. It will be incorporated into stock charts, annual reports and employee compensation plans. Measuring something is the first step toward improving it, and in today’s competitive world, everyone is trying to improve.