TRACKING THE CURRENT.
Saoirse Kennedy, Analyst Consultant at GreySpark Partners explains how Transaction Cost Analysis is following the route of trading electronification in its advance across asset classes.
Post-financial crisis regulations and buyside client expectations are a central force in this shifting landscape that is driving a change in emphasis from post-trade TCA, to pre-trade and real-time TCA.
TCA is emerging as one of the next great talking points in the capital markets technology space, following in the footsteps of low-latency technologies, digital investment banking and swap execution facilities. This is driven largely by the buyside, and highlights the significance of cost control in a post-crisis financial industry that is just beginning to grasp the reality of its increasingly frugal existence. TCA should be considered as a renewed competitive differentiator with investment in a robust cross-asset tool essential in today’s climate. Next generation TCA solutions are rapidly becoming critical in a marketplace where increased regulatory demands can negatively impact returns.
The current TCA landscape is one that is no longer characterised by an equities market using post-trade TCA solutions but as one that incorporates all aspects of the trading lifecycle, across multiple asset classes. This refocus is due, in part, to a general trend toward electronification which is itself catalysed by the recent spate of regulations as shown by Figure 1.
Regulators and clients both demand better cost transparency
Financial market regulations since the 2008 financial crisis, particularly those regarding Best Execution and increased transparency in trade decision-making have provided TCA offerings a new impetus. Buyside firms are now pressed to justify risky strategies in asset classes beyond equities with this pressure coming from both regulators and clients. These firms look to TCA to address this need – having multiple tools to measure Best Execution is considered prudential. TCA allows the buyside and sellside relationship that was eroded during the crisis to regain trust, particularly due to the pre-trade and real-time offerings that are increasingly available, which grant greater cost transparency.
Asset class coverage is increasing as Electronification Progresses
Traditionally only an equities phenomenon, over the past three years TCA solutions have begun to seep into the FX space. This trend is expected to continue into other asset classes as both the buyside and sellside demand increasingly granular analysis and decision-making techniques when making investment choices. This expansion of TCA across asset classes is following the path set out by trading electronification (see Figure 2). We observe a gradual movement to FX, fixed income and futures businesses with derivatives businesses bringing up the rear due to the complexity of analysing costs for these relatively complex products. As reporting requirements across asset classes increase there will be a deluge of new data for use in cost analysis. Furthermore, FX mispricing scandals, such as State Street overcharging pension funds, have triggered an increased demand for TCA in a market where regulators are yet to insist on centralised trade reporting.
The FX market is thus the latest target for TCA solutions. Buyside firms are acknowledging the costs of trading in FX markets and the benefits a TCA solution can bring. There are, however, some limitations. The first is a general lack of transparency in the D2C space meaning that banks do not necessarily share the information required to make a proper assessment of transaction cost. Secondly, the large, global, 24/7 nature of the FX market makes TCA in the FX space more complex than for equities. A comprehensive FX TCA offering should bring a lot more to the table than a rebranded equities product. It should give due consideration to the nuances of trading in an FX market, handling the nuances required for measuring the cost of both liquid and illiquid currencies with access to data sources relevant to the currency being traded.
TCA techniques are encompassing the entire trading lifecycle
There is acknowledgement that TCA improves trading outcomes. However, there is also a general sentiment that TCA tools could be improved to have a better impact on trading outcomes. This is where real-time and pre-trade TCA comes to the fore. The impact of electronification has aided TCA’s push into the pre-trade, real-time space. As a post-trade function, TCA serves to provide an analysis of the cost of executing a trade after the event, providing a measure of a trade’s efficiency. Pre-trade TCA is actually a misnomer, however, as it provides a transaction cost estimation, rather than the analysis of a past event. Pre-trade TCA offers an additional opportunity for risk assessment of pricing prior to trading based on the assumption that the explicit costs of a trade can be estimated from those of past trades. This is not a fool-proof approach but it does provide a good starting point for improved investment decision-making. This permits a more comprehensive analysis prior to trading and an additional input to algorithmic trade decisions. Pre-trade TCA essentially aids smoother electronic execution by providing this additional input to the trading decision.
Understanding the pre-trade TCA process gives a grounding upon which to conceptualise real- time TCA, it also allows a view of how market risks are being mitigated, allowing the buyside greater confidence in their trading strategies.
The pre-trade TCA process hinges on the following:
• Pre-trade data analysis
– pre-trade analytics provide instrument-specific, market-related and trade-specific information that characterise and assess the difficulty involved in a proposed trade. The market impact and opportunity costs of a trade are assessed by this with trading strategy adjustments being made for onerous trades.
• Cost and risk estimation
– consideration is given to the implicit costs of a trade that are influenced by the trading strategy and can, to a certain degree, be controlled. Central to these estimations is an understanding that cost estimates include a risk parameter and both vary depending on the implementation strategy. This estimation allows for an assessment of alternative strategies.
• Trading strategy optimisation
– optimisation should find an appropriate trade-off between cost and risk, managing the conflicting outcomes of market impact and timing risk. This can, generally speaking, be achieved by minimising the cost subject to a specific level of risk, balancing the trade-off between cost and risk, or maximising the probability of price improvement.
Real-time TCA is growing in eminence as the demand for real-time decision-making increases on electronic markets; this is particularly relevant where the impact of event-driven market volatility can be incorporated into the real-time cost analysis. These types of events can all contribute to ‘slippage’ and real-time TCA mitigates this. It reduces the lost opportunities in the trade-off between time and price by neutralising the time element. The essence of the real-time element is that, theoretically speaking, returns should be improved based purely on a price decision as the impact of other temporal factors affecting execution price are taken into account prior to the decision to trade. A continuous stream of analytical data should allow trade execution strategies to be updated to reflect changing market conditions without delay.
There is a cost consideration in the choice of TCA strategy – whether to choose post-trade, pre-trade or real-time analysis. Post-trade analysis, based on historical data, can be gathered at a minimum of cost. Pre-trade has the further requirements of cost and risk estimations, pre-trade data analysis and trading strategy optimisation, incurring additional costs. Real-time analysis, in addition to the costs of pre-trade analysis, requires a real-time data feed, further increasing costs. Though there is a cost increase associated with each level of analysis this must be considered in light of any reduction in transaction costs that may be gained.
The renewed emphasis on TCA promises to be an exciting development as businesses continue to focus on cost reduction and transparency in the wake of the credit crisis. And, perhaps like never before, the increasingly electronic marketplaces of today should provide the data needed to build real, bottom-line-affecting solutions in this space. ■
©Best Execution 2013