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The Future of Trading

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Calculating Cost First, Trading Second

November 4, 2010
By Chris Kentouris

Transaction cost analysis, often called TCA for short, is now a fundamental metric used by buy-side firms and their broker dealers to analyze just how well they have executed an order.

But the financial crisis and the explosion of high-frequency trading have changed the rules of the game. No longer are standard benchmarks such as implementation shortfall and volume-weighted average price considered sufficient for traders to understand just how to adjust their strategies fast enough to effectively compete in a fast-paced world of algorithmic and high-frequency trading.

That is because those benchmarks do not consider the specific circumstances of each trade, the types of orders used or the investment style of the portfolio manager. They also sometimes are not fine-tuned enough to work with financial instruments other than equities. And then there’s speed. Firms may soon be picking a strategy at the instant of triggering a series of mathematical instructions to execute orders. The right strategy may depend on a cost analysis done at that moment.

“Firms that have embraced TCA are moving beyond simple measurement and intermittent evaluation of execution strategy to actually adopting strategies at the point of trade,” says Mayiz Habbal, senior vice president of the securities and investments group at Celent, a New York based research firm.


While broker dealers are the main providers of TCA tools, fund managers are increasingly turning to third-party suppliers they feel offer the independent metrics they need. Some of those suppliers are now leading the way to more granular post-trade and pre-trade analysis even going as far as to link the two in close to real-time.

Here is how the new gameplan works. Traders can input all the pertinent details of the transaction, such as number of shares, price, fees or commissions, after it has been executed into a tool almost immediately after execution. The results will then be integrated into a pool of such details. Then, the pool can be used to perform pre-trade analyses, once a critical mass of data is aggregated. Then, the tool will calculate the expected costs, in advance, and recommend what trading strategies to use. The recommendations will include the algorithm, the pace and timing of the execution. In some cases, the trader doesn’t have to make routine decisions. A machine can just crunch the numbers and automatically select an optimal algorithm before and even as the trade is being executed.

“The failure of standard TCA to consider the circumstances of each trade not only reduces the ability to rank brokers but also fails to support the traders need to design customized trading strategies,” says Henri Waelbroeck, director of research for Pipeline Trading Systems, a New York-based transaction cost analysis provider. “In addition to choosing between brokers, traders must also choose between aggressive and opportunistic strategies.”

Implementation shortfall, the difference between the price at which a trade is executed and the price at the time the order was sent in by the portfolio manager, doesn’t tell a trader how well the trade was executed. The biggest factors determining implementation shortfall are short-term alpha and opportunity costs when some shares are unfilled.

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