Imperfect Knowledge: International Perspectives on Transaction Cost Analysis
Across the US and Europe, TCA is closing in on ubiquity: its usage is widespread because the desire to measure performance cuts across nearly all trading styles, investment strategies, geographies and even asset classes. It does not matter if you are a trillion-dollar quantitative mega-manager or a classic bottom-up stock-picker with $50 billion in assets. Both are looking at post-trade TCA. Of course, just because our PCs both have Microsoft Word does not mean that we use them in the same way. The question today is not whether TCA is on the desk, but how it impacts trading.
The magnification of transaction costs is intensifying in the equity markets as firms apply the analytics more broadly. Fundamental firms are incorporating broker-focused TCA into calculating the value of each sell-side relationship. A few firms take a more introspective approach. It is the buy-side trader that is scrutinized, and compensated accordingly. Quantitative managers are deeply embedding homegrown market impact estimates into their black box trading modules.
However, the limits—or benefits—of TCA have become clearer over the last few months. The surge in volatility has humbled much of the market, and TCA is no different. Cost attribution is more complex when prices break through probability ranges. It seems that there are more costs that are beyond the control of the trader. There are times when the diagnosis does not come with a prescription.
Regulation and transparency are the keys to opening up the possibility of more precise execution measurement. There is a symbiotic relationship between these two forces. The small number of European traders still free from the impact of TCA is dwindling, as MiFID (Markets in Financial Instruments Directive) —with its more stringent definition of best execution—exerts its influence. By 2009, 85% of European traditional asset managers will be looking at TCA, up from 70% today. At the same time, as usage spikes, there is hope that European TCA will become more accurate, as reporting requirements force more trade information into the public domain (though trade reporting has become more complex for now).
Other asset classes are being overcome by the will to measure trading costs. As pension plans and traditional asset managers pile into alternative asset classes, innovators and aggregators are busy cooking up relevant benchmarks for listed derivatives, FX and more.
Brokers are playing a critical role in this development. Bulge-bracket brokers have been busy in the last two years developing options and FX algorithms. TCA for these products will follow as a way to demonstrate execution. The absence of existing benchmarks creates the possibilities of defining execution quality. The use of these benchmarks will in turn change behavior. Brokers who made their mark in electronic trading and TCA in equities are getting into the game, buying up names in other asset classes with a view to expanding their franchise.
The TABB Group study on Imperfect Knowledge: International Perspectives on Transaction Cost Analysis
This report focuses on how the buy side views post-trade and pre-trade TCA, including how frequently these data are reviewed; the different benchmarks against which traders are measured and how they impact their compensation; and the impact of TCA on portfolio management. We also look at how usage patterns differ in the US compared to various parts of Europe, as well as the viability of TCA in the FX market and in other asset classes.
Among equity traders, we spoke to 137 buy-side traders, with a slight edge to US equity traders. Traders only addressed the primary market(s) in which they trade. It is much more likely that a European trader is looking at TCA across multiple markets, whereas US traders are focused solely on their domestic market. In addition, data has been collected from 27 US FX traders.