Transaction cost analysis (TCA) is not a new concept, but it is becoming an increasingly important feature of fixed income, foreign exchange (FX) and equity markets. Insufficient analysis of transaction costs has obvious implications for pension funds, hedge funds and asset managers in terms of potentially diminished capital and lower investment performance. 

A Markit whitepaper in April found that 70% of respondents used TCA for equities, compared to 52% for fixed income and 53% for FX transactions. The most common function of TCA was to improve performance and reduce trading costs, followed by broker evaluation, client reporting, strategy backtesting and compliance. 

Systems provide two types of information – daily reporting of exceptions and anomalies as well as statistical analysis on an aggregate level – observes David Weisberger, managing director and head of trading and quantitative services at Markit. 

“Daily reporting is typically achieved by comparing every trade to participation-type benchmarks such as volume-weighted average price during the trade,” he says. “It is a useful metric to show how the trading strategy deviated from the average trading in the security during the period. On its own, it should not be used to draw too many conclusions, but it is descriptive of average trading.” 

Aggregate level statistical analysis can be used to compare venues, trading strategies, algorithms and traders based on a combination of pre-trade benchmarks and context-sensitive metrics such as post-trade market movement and liquidity measurement. 

According to Michael Beattie, director product management at Charles River Development, an effective TCA service has four attributes. Firstly, it must have actionable results, where data returned can be translated into changes in trading decisions. 

It must be timely, so the results should be based on recent trading activity and current orders. It must be relevant, so the datasets used to perform the analysis should be comparable. And finally it must be easy to obtain, so the data collection and analysis views should not be disruptive to trading workflow or require traders to use multiple disparate systems. 

“There are two core drivers shaping TCA across asset classes – differing liquidity profiles across equity, FX and fixed income as well as the availability of structured market data,” explains Beattie. 

“For equity, it is used to look at portfolio manager performance and for broker and venue analysis. FX TCA is lagging behind equities in that there is no centralised market data available and no clear posttrade source, while TCA data providers face a difficult task with fixed income given the breadth and opacity of the market.” 

Consistency vital 

To enable clients to use the service with confidence, it is imperative that the analysis is totally unbiased, says BestX director Pete Eggleston. “It is also essential that a consistency of approach is adopted to allow fair and effective performance comparisons across venues, counterparties and products,” he says. 

“Finally, given the growing complexity of the FX market – order-driven, commission-based models in OTC markets and ongoing liquidity fragmentation – a rigorous framework is required that allows the total cost of execution to be measured, including the implicit costs such as market impact.” 

Peter Weiler, EVP sales & client service at Abel Noser says vendors must have a large universe and sound methodology to draw on when producing peer comparisons. 

“They must also measure trading over a spectrum of time periods – real time, daily, next day and multiday – and investment horizon. Not only should orders be measured, but fills and venues along with trade surveillance tools should be part of the offering.” He also notes that issues such reporting delays may affect the analysis. 

Willis Towers Watson investment consultant Ed Hails adds cost to the list of considerations: “There is a wide range of fees charged for these services, some of which are too high relative to the potential benefits for a small or medium-sized asset owner.” 

He also warns that the trend for greater use of pooled funds can limit the benefit of TCA to the investor. “TCA is most often used by asset owners as part of transition management projects to assess the success of the transition and in recent years a number of transition managers have started including independent TCA as part of their service,” he adds. 

Within each firm, there are multiple different audiences that are interested in varying types of analysis, notes MarketAxess head of research, David Krein. Risk and compliance teams are keen to learn more about exceptions and outliers, while traders are interested in trading performance at a basis point level. 

“Given how new TCA is in the fixed income markets, the analysis is evolving and market participants are continuing to educate themselves,” he adds. “It is the responsibility of the provider to organise the information in such a way that the analysis is most useful, consumable and applicable.” 

Trade lifecycle 

Another way to look at usage is the development of tools across the trade lifecycle, with post-trade analysis now being supplemented by pre-trade and at-trade analysis. It may be of greater value to end users and their clients, says Saoirse Kennedy, senior consultant at GreySpark Partners. 

“This is driven by regulatory pressures such as best execution and the need for greater transparency in financial markets,” she says. “The sell side is using TCA as means of reassuring their client relationships. As returns on investment have declined, it offers a tool to shed light on areas where costs can be better controlled and tightened.” 

John Halligan, president of Global Trading Analytics observes that TCA clients range from pension funds, asset managers and hedge funds to broker-dealers, transition managers and multinational corporations. 

The analysis can identify and help manage costs generated from any part of the trading process and enable clients to measure and attain best execution, which can be used to satisfy regulators, clients and boards, he says. “It can also be used to demonstrate to potential clients and for RFPs that the firm has a process in place and is actively managing its trading costs.” 

Targeted TCA 

TCA has been known to impact the trading strategies of firms using the information to perform model analysis before conducting trades. However, the data produced is only useful if firms have the staff, time and ability to use it, which is why users are asking vendors for more concise analysis. 

“The metrics and benchmarks used in TCA are very userspecific,” observes Kevin Kozlowski, institutions analyst at Greenwich Associates. “The traditional principles – reporting and benchmarking – have not changed and real time TCA and venue analysis continue to be key needs for buy-side users. Providers are beginning to attempt to offer these services to a wider array of clients.” 

Additional benchmarks are being introduced and the requirement for more accurate time-stamping in MiFID II will provide for more granular analysis of trading data, such as how the market looked when the order was placed, which can be used to try to understand market impact adds Andy Mahoney, director of business development at FlexTrade. “We perform quite a lot of data scrubbing and also some data interpolation to ensure that there is a consistent view across venues and brokers,” he says. 

ITG director of analytical products and research, Michael Sparkes, says that there has been a shift from volumeweighted average price (VWAP) as a primary benchmark towards implementation shortfall, otherwise known as slippage. 

“This represents the movement in price during the process of trading, made up of impact and delay costs,” he says. “A key factor in assessing slippage is to adjust for the difficulty of the trade, so a good process for modelling the expected cost is vital. Peer analytics are also widely used – for this approach a large volume of comparable trades are required to get good granularity in the comparisons.” 

According to Abel Clark, managing director of the financial business at Thomson Reuters, for larger buy-side firms – especially those which execute across a large number of sell-side counterparties – TCA should ideally be provided by an independent source. 

“This is in the interests of consistency and comparability and to avoid the potential conflict of interest associated with a broker-owned service,” he explains. “Sell-side firms are both consumers and providers of TCA to their buy-side customers as a means of demonstrating the quality of their execution performance.” 

Appreciation of the merits of TCA is already widespread. Under MiFID II, which brings with it a best execution requirement across a broader range of asset classes including fixed income, listed derivatives and FX (excluding spot trades), it is likely that its adoption will continue to grow.