This article summarizes results of our extensive empirical study motivated by the intuitively appealing statement that institutional clients’ average transaction costs are sensitive to market conditions. Using a comprehensive sample of client execution data covering two years of trading, we confirm that average cost of institutional trades varies considerably and systematically with volatility, volume, and trade imbalance surprises. For the overwhelming majority of buy-side institutions, implementation shortfall is higher than normal when volatility and volume exceed their historical average values. However, the deviations of trading volume in excess of the values typically observed in high volatility conditions dampen the effect of high volatility environment on execution costs of institutional orders. We document a strong dependence of transaction costs on contemporaneous trade imbalances, which is amplified by higher than normal contemporaneous volatility. We observe that cost curves are more sensitive to order size at the times of less favorable buy-sell trade imbalances, reflecting the role played by directional market pressure indicators. In summary, buy-side institutions should not neglect market conditions monitoring, as failure to adjust promptly to market conditions may result in deteriorated performance and missed cost savings opportunities.
While Best Execution and Transaction Cost Analysis (TCA) are well-established in equity trading, other asset classes have been slower to adopt such techniques due to limitations in market data and market structure characteristics. In Over-thecounter (OTC) markets there has typically been no requirement for central reporting, making it difficult to demonstrate best execution in the same way as for equities. This is beginning to change due to pressure from regulators and end investors who require higher standards of information. Market structure changes, with more electronic platforms taking increasing shares of trading, are also enabling more precise analysis. Over the last three or four years, Foreign Exchange (FX) TCA has become increasingly mainstream for asset managers, while one recent survey shows that in the past year, Fixed Income TCA has become the fastest growing category of analysis1. These trends are expected to continue, not least in the light of MiFID II regulations.
“The most valuable commodity I know of is information” – to quote Gordon Gekko from the 1987 movie classic Wall Street. This line has never been more significant than in today’s data-fuelled financial markets, where detailed analysis of information can provide that all important competitive edge – both now and in the future. To achieve this, firms are looking towards Transaction Cost Analysis (TCA), which enables them to reduce costs and hone trading strategies.
TCA providers must communicate better, but they need help from their constituents. To this end, we applaud the efforts of FIX Protocol groups, led by Mike Caffi of State Street Global Advisors and Mike Napper, from Credit Suisse. They recognize concerns that inconsistency in TCA terminology across providers presents practitioners with challenges. A consolidated glossary is being developed, and as of this writing, groups devoted to TCA for FX, for Fixed Income, and for futures/listed options are being created.
Final Results as of 7/17/2013
The developed markets outside of Asia finished 2012 with yet another month of trade outflow while Asian developed markets saw another month of trade inflow, making December 2012 the third consecutive month. The financial sector in both the developed markets and emerging markets saw significant trade inflow. Trade costs decreased in both the developed and emerging markets from November.
In this interview from the Winter 2012/13 issue of Best Execution magazine, Jim Cochrane talks about the challenges of achieving best execution in the FX market.
In November 2012, MSCI World Index and MSCI North America indices continue to
experience trade outflow, althought not to the level of magnitude in September
2012. Similar to October, Asian regions continue to see trade inflow. Regional
emerging markets experienced trade outflow. Resources sectors of MSCI World and MSCI North America indices saw significant trade outflow. For the regional emerging markets, information technology sector saw trade outflow. Trade costs decreased in both the developed and emerging markets from October.