With increased industry demands for transparency, TCA has been promoted from bit part to star player, says Richard Hooke, of Fidessa
One of the consequences of the credit crunch is the demand for greater levels of transparency at each stage of the order flow. Documented proof of skill, accuracy and integrity between fund managers and their brokers has become a tangible asset. Custodians, trustees, consultants and investors themselves are making more forceful demands for their agents to open their activities to sunlight and scrutiny.
In these challenging market conditions, the demand for transparency is accompanied by a need to impart greater cost controls and efficiencies throughout the transaction cycle. Buy-sides are looking for better value from their broker relationships and weighing up their choices for each trade: to place their faith in automation and self-directed trade or to shun algos and computer models and opt for the experience and skill that comes with more high-touch channels. Many are considering broadening their broker list to ensure that no sources of liquidity escape them, whereas others are looking to direct their efforts and their commissions to a narrower group of trusted, full-service brokers.
It has proved to be a fertile combination for trade analytics. Asset managers are looking for more comprehensive information regarding order execution, both to measure performance of their chosen brokers and to demonstrate value to their investors. Transaction cost analysis (TCA) in particular has been promoted from bit part to star player.
When broker fees and commissions were decoupled from research costs, part of the true price of transactions immediately became more obvious to all observers. However, what the ban on bundling and softing couldn’t reveal was the hidden costs involved in each transaction: investment delay, price appreciation, market impact, timing risk and opportunity cost, known as implementation shortfall. Calculating these costs has become critical and the credit crunch has only hastened a process that was already underway. TCA’s journey into the spotlight has also been driven by regulatory pressures to demonstrate best execution. TCA enables asset managers to measure performance at various different stages in the investment management process. They can take it all the way upstream to establish how their own decision-making process, and the time it takes to make an instruction, impacts the cost. Similarly it can be taken downstream, where there is significant buy-side interest around measuring the execution performance of a brokerage firm as a whole, or of particular strategies offered. It enables buy-sides to assess which brokers are achieving their benchmark, and which are falling short of expectation, and gives them documented evidence of the true cost – measured by implementation shortfall, fees, commissions and decoupled research costs.
Buy-side firms are also using TCA to assess the relative costs of the venues used for execution, and are able to engage with broker strategies on a more informed level. Since the abolition of the concentration rule to allow a multiplicity of execution venues was explicitly designed to enhance competition and consequently services, TCA plays a valuable role in the post-MiFID, post-RegNMS securities markets. It enables traders to measure not only implementation shortfall – perhaps the most obvious and easily measurable performance indicator – but other execution benchmarks including the widely deployed Volume Weight Average Price and other algorithms.
The importance of TCA in today’s markets is evidenced by the prominence of several third-party specialist providers. Asset managers package up the data relating to that month’s activity and ship it out to the specialists, who then crunch the numbers and compare the results with various sets of market data and produce reports about how effective that month’s trading has been in terms of certain absolute measures. It is, inevitably, a data-intensive process. Not only does it rely on the trade data held by the buy-sides in their order management systems, but market data as well. The aim is to identify the spread between potential and actual execution costs, and then establish whether there are systemic reasons for that spread.
The process provides valuable insight on broker and venue performance. Many of the specialists can also conduct peer reviews to give buy-side firms an indication of performance and efficiency in comparison with outfits of a similar type or size.
In the traditional model, TCA is a post-processing problem. Measuring transaction costs on a monthly or even quarterly basis provides a post-facto illustration of performance metrics, but it does not allow for an agile response when those metrics are poor. Nor is it entirely suited to the realities of trading in a multi-venue marketplace, where orders can be merged and split, where parent and child orders are divided and reconciled, and where trades can be cancelled or executed in a different order to the way they came in. Accurate and precise analysis of trading costs is not a straightforward process, and is naturally made more difficult in complex trading scenarios such as these.
Therefore there is a need to bring cost analytics in line with the trading process itself. Liquidity fragmentation and high levels of program trading on the sell-side have placed greater emphasis on intra-day transaction cost analysis. Intra-day analysis is now becoming more and more mainstream to the point where many now expect it to become an industry standard within the next three or four years.
Historically it has been difficult to get all the data together, but order management systems now offer simple cost numbers so that traders can see an implementation shortfall measure between their order’s arrival price and their average execution price in real time. In addition, end-of-month file extracts can export trade information direct from the OMS out to third-party providers, while integration with the analytics providers’ own systems can bring estimated transaction costs into the blotter.
This ups the potential impact of TCA, and adds value by giving asset managers an indication of what the ‘hidden’ costs are likely to be in real time. It complements monthly in-depth analysis by providing early information within the reporting window, and gives buy-side traders the opportunity to alter their actions or change the trading destination of the proposed order before it is executed. The speed of reaction is no longer limited by the cycle of the more detailed analysis.
The key is the incorporation of pre-trade cost analytics, which try and predict the likely cost based on the characteristics of the deal, the stock concerned and the market involved. Although not a trading decision tool, it can nonetheless be used to spot which potential transactions or trades will be in need of more attention from brokers and which can be routed on a zero-touch basis. The ultimate goal is a model where pre-analysis of orders is conducted to calculate expected or estimated cost, to aid decision-making on how to execute and measure performance against the estimated cost.
Nonetheless, problems remain with this model. To use third-party analytics effectively, the buy-side needs to indicate what kind of order they are undertaking, which introduces confidentiality issues. Consequently, there has been a tendency to fudge the identity of particular trades and hide them among other data, which inevitably affects the quality of the analytics being returned. Furthermore, where broker-provided analytics are used, they are limited to their own order flow: they don’t have the wider picture drawn from the whole book. The buy-side must find ways of addressing these challenges. The rise of broker-neutral services offered by third-party specialists goes some way to alleviate the fears of asset managers determined to plug any potential source of information leakage.
Intra-day analytics is a significant advance for the buy side, and one that has been hovering on the sidelines for some time. Although not intended to replace monthly analysis, whose thoroughness remains highly desirable, intra-day analytics provide a value complement to it. Enabled by developments in buy-side OMS technology, these advances give buy-side firms an extra guide in the ongoing search for best execution.
Richard Hooke is buy-side product director at Fidessa
©2010 funds europe