Published On: Tue, Mar 30th, 2010

Transaction Cost Analysis Explained

tcaTransaction Cost Analysis (TCA) was spawned from the notion of Best Execution as mandated by RegNMS and MiFID. Broadly, it is the measurement of the costs to trade. There are 2 components of trading costs; explicit which are commission, taxes and exchange fees and implicit costs which are measured in opportunity cost, market impact cost and the delay between trade decision and implementing this trade. Implicit costs are generally higher than explicit costs.

TCA is intended to measure the costs of trading at several points along the trading life cycle to identify where undo costs are borne and then to compare those costs against a benchmark such as VWAP or Implementation Shortfall (IS).

There are several factors affecting the cost to trade such as how the trade is executed i.e. DMA, Algo, high touch or on crossing networks. The time frame which the trade is executed – large Average Daily Volume (ADV) orders may need more than one day to complete. And the nature of the name such as volatility, liquidity constraints and the size of the spread.

All trades are not created equally and as such it behooves the buy side to have as many tools at its disposal to achieve Best Execution. But before they know what tool to use the buy-side first must identify where costs to trade are being exacted. Perhaps the portfolio manager is sending small orders to the trading desk instead of one large order which would allow the use of block trading to help reduce execution cost. Perhaps the broker the buy side is using has poor access or limited expertise in a certain market resulting in higher execution costs. It is the intention of Transaction Cost Analysis to identify inefficient segments of the trading process and adjust how these segments are traded to minimize overall trading costs

It’s probably obvious to you but a comprehensive and on-going implementation of TCA will necessarily reduce trading costs and help a fund realize better performance against its peers who might overlook this process. If an examination of the costs to trade can save, as an example, 10bps on a USD1 billion fund who turns over half its portfolio annually this translates into USD500,000 in savings. Any serious sell side will have a TCA facility available and any buy-side, as a prudent fiduciary, should look to them for a more detailed explanation of how they can help their funds save money.

One last thing. AsiaEtrading.com is running an opinion poll on this subject and would be very grateful to have your vote. Please click HERE

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