The Future of Trading
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Calculating Cost First, Trading Second
November 4, 2010
Just how effective is such switching? From January 2009 to May 2009, AllianceBernstein conducted a joint study with Pipeline Trading to define "adverse selection" and measure the effectiveness of predictive switching on adverse selection costs. Alliance Bernstein used a dark aggregator – a program that aggregated orders in dark pools that would match a given set of orders at a given price from a different sell-side provider while Pipeline ran its Algorithmic Switching Engine. The study showed that Pipeline's predictive switching strategy -- as compared to a common dark aggregator strategy -- saved as much as 70 percent of the costs attributed to adverse selection. The engine switched strategies, on the fly, when it saw that the original algorithm was wrong.
While stocks remain the dominant asset class for transaction cost analysis, there has been a growing push for TCA in other products which have to date been limited in large part because of the lack of sufficient market data and interest from fund managers.
As fund managers now understand the importance of including other financial instruments as asset classes in their analysis of best execution they are demanding the same sort of TCA.
Nowhere is the need for TCA more pressing than in foreign exchange transactions as was evidenced by a lawsuit filed last year by California's largest pension plans – the California Public Employees Retirement Plan and California State Teachers Retirement System -- against Boston-headquartered custodian bank State Street. They allege that State Street fraudulently priced foreign exchange trades which resulted in extraneous costs of over $56 million since 2001.
But performing TCA on FX trades is no easy task. While the market for foreign exchange trades is highly liquid, it is also highly fragmented across dozens of over-the-counter platforms. Making matters more complicated is the fact that not all custodian banks timestamp their trade executions, which would permit the fund manager to use benchmarks traditionally adopted for the equities market to determine values at any given point.
"For fund managers which have time-stamped trades we can offer traditional equity metrics and for those which do not we can perform analysis that is analogous to volume-weighted average price measurement ," says James McGeehan, chief executive officer for FX Transparency, a Boston-based firm specializing in transaction cost analysis for foreign exchange transactions.
FX Transparency also provides fund managers with a comparative analysis of how well their execution costs rank against 100 fund managers. For those who want to improve their execution, the firm then counsels fund managers and plan sponsors on execution strategies. McGeehan declined to specify what those were for competitive reasons but claims that one plan sponsor is saving $5 million in costs annually based on FX Transparency's advisory work .
PHONING IT IN
As more fund managers incorporate options into their trading strategies the need for transaction cost analysis becomes more obvious. But the continued widespread use of phone-based trading continues to prevent the buyside from capturing trade information and conducting TCA. And until recently the options market has lacked appropriate benchmarks.
“Due to the lower trade volume for options, traders need liquidity recovery, order flow, market impact, execution quality and trading cost metrics that rely on factors other than the Options Price Reporting Authority’s (OPRA’s) consolidated tape in understanding each transaction,” says Alan Shapiro, president of Transaction Auditing Group (TAG), a New York-based transaction cost analysis and execution quality provider. “That means a firm also needs to analyze all of an option’s quotes as well, which requires the capture and archiving of millions of market data ticks per day.”