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Huw Gronow, Director, Equities Trading, and Mark Nebelung, Managing Director of Principal Global Investors, make the case that TCA should be part of pre-, during, and post-trade analysis.

Transaction Cost Analysis (TCA) has evolved significantly with the advent of technology in trading, and thus the ability to capture incrementally higher quality data. Historically the preserve of compliance departments was to examine explicit costs only as a way of governing portfolio turnover; this evolution provides institutional asset managers with several opportunities: the ability to quantitatively assess the value of the trading desk, the tools to form implementation strategies to improve prioritisation to reduce trading costs, and therefore improve alpha returns to portfolios.

Cost analysis models, methods and techniques have blossomed in the environment, propagated not only by technological advancements, but also in the explosion of data available in modern computerised equity trading.

The benefits of applying cost analysis to the execution function are manifold. It empowers the traders to make informed decisions on strategy choice, risk transfer, urgency of execution and ultimately to manage the optimisation of predicted market impact and opportunity costs.

Although maturing, the TCA industry still has some way to go to fully evolve, and that is largely a function of a characteristically dynamic market environment and non-standardised reporting of trades and market data (the so-called “consolidated tape” issue). Moreover, with the advent and increase in ultra-low latency high-frequency short term alpha market participants (“HFT”), which now account for the majority of trading activity in US exchanges and who dominate the market, the exponential increase in orders being withdrawn before execution (with ratios of cancelled to executed trades regularly as high as 75:1) means that there must be an implied effect on market impact which is as yet unquantified, yet empirically must be real. Finally, fragmentation of equity markets, both in the US and Europe, provide a real and new challenge in terms of true price discovery and this must also by extension be reflected in the post-trade arena.

Nevertheless, waiting for the imperfections and inefficiencies in market data to be ironed out (and they will surely be in time, whether by the industry or by regulatory intervention) means the opportunity to control trading costs is wasted. You cannot manage what you don’t measure. Therefore, with the practitioner’s understanding allied to sound analytical principles, it is very straightforward, while avoiding the usual statistical traps of unsound inferences and false positives/negatives, to progress from an anecdotal approach to a more evidence-based process very quickly.

On the trading desk, the ability to leap forward from being a clerical adjunct of the investment process to presenting empirical evidence of implementation cost control and therefore trading strategy enhancement is presented through this new avalanche of post trade data, which of course then becomes tomorrow’s pre-trade data. The benefit of being able to enrich one’s analysis through a systematic and consistent harvest of one’s own trading data through FIX tags is well documented. The head of trading then arrives at a straight choice: is this data and its analysis solely the preserve of the execution function, or can the investment process, as a whole, benefit from extending its usage? We aim to demonstrate that both execution and portfolio construction functions can reap significant dividends in terms of enhanced performance.

PM Involvement
Portfolio managers’ involvement in transaction cost analysis tends to be a post-trade affair at many firms, on a quarterly or perhaps monthly basis, that inspires about as much excitement as a trip to the dentist. It may be viewed as purely an execution or trading issue and independent of the investment decision making process. However, there is one key reason why portfolio managers should care about transaction costs: improved portfolio performance. The retort might be that this is the traders’ area of expertise coupled with a feeling of helplessness on how they could possibly factor transaction costs in. The answer lies in including pre-trade transaction costs estimates to adjust (reduce) your expected alpha signal with some reasonable estimate of implementation costs. You can now make investment decisions based on realisable expected alphas rather than purely theoretical ones.

A key characteristic of many investment processes that make some use of a quantitative alpha signal process is that you always have more stocks (on a stock count basis) in the small and micro-cap end of the investable universe. There are simply more stocks that rank well. This is also the same part of the universe where liquidity is the lowest and implementation shortfall is the highest. If you don’t properly penalise the alpha signals with some form of estimated transaction cost, your realized alpha can be more than eroded by the implementation costs.

Proving the Point
To illustrate the impact of including transaction cost estimates in the pre-trade portfolio construction decision making process, consider the following two simulations. Both are based on exactly the same starting portfolio, alpha signals and portfolio construction constraints. The only difference is that in the TCs Reflected simulation, transaction costs were included as a penalty to alpha in the optimisation objective function whereas in the TCs Ignored simulation, pre-trade transaction cost estimates were ignored. The simulations were for a Global Growth strategy using MSCI World Growth as the benchmark, running from January 1999 through the end of June 2012 (13.5 years) with weekly rebalancing. They were based on purely objective (quantitative) alpha signals and portfolio construction (optimisation) with no judgment overlay. Transaction cost estimates were based on ITG’s ACE Neutral transaction cost model. Starting AUM was $150 million. Post-transaction cost returns reflect the impact of the transaction cost estimates for each trade.

Edouard Vieillefond of Autorité des Marches Financiers looks at the factors that contribute to financial stability and how investor choice needs to be balanced with investor protection, market fairness and efficiency concerns.

FIXGlobal: How can the Commission and the European Securities and Markets Authority (ESMA) ‘encourage’ institutions to trade via multilateral facilities?

Edouard Vieillefond, Autorité des Marches Financiers (AMF):
Market transparency, efficiency and integrity are essential to financial stability and to ensure that financial markets continue to play their core role of financing the real economy.

In the context of the financial crisis, in 2009 the G20 leaders declared that “all standardized over-the-counter (OTC) derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest”. In order to implement these objectives, in 2012 the International Organization of Securities Commissions (IOSCO) identified some key characteristics that electronic trading platforms should fulfil in this context, amongst which were pre- and post-trade transparency and “the opportunity for platform participants to seek liquidity and trade with multiple liquidity providers within a centralised system”. We believe that this multilateral criteria, which is not consensual amongst regulators, is absolutely essential in defining what a trading venue is and ensuring the real efficiency of the price formation process on financial markets.

As regards the perspective of the MiFID review, in Europe the Commission proposes an obligation for derivatives to be traded on multilateral trading venues, which shows progress in the right direction. On cash securities, unregulated trading has developed over recent years, including in the fully OTC bilateral space. The Commission’s aim of catching all these new trading spaces within a new EU regulatory framework is a positive one. However, without clearly defining the boundaries of the European trading environment, it leaves aside the possibility for new trading concepts to be developed, including bilateral ones. It also leaves aside more structural issues – such as the role that we want financial markets to play in the near future with regards to the real economy. An essential first step for legislators and regulators in Europe would therefore be to define in greater detail what the EU trading space shall consist of; and then to incentivize trading of standardized and sufficiently liquid financial instruments on genuine trading venues such as exchanges and multilateral trading facilities (MTF).

FG: Where is the balancing point between investor choice and encouragement towards certain venues?

EV: Investor choice is of course to be kept fully flexible but also, on the regulatory side, to be balanced with investor protection, market fairness and efficiency concerns.

In Europe, MiFID has led to excessive market fragmentation, despite the legitimate intention of the directive to enhance competition between exchanges and multilateral trading facilities. This approach has produced very mixed results, including no real overall cost reduction for final investors, an increase in dark trading and a decrease in the quality of pre- and post-trade transparency to the detriment of the market as a whole.

If financial markets are to remain a reference and to serve investors and the real economy, an essential step in reviewing MiFID is to ensure that orders be primarily executed on genuine trading venues. So, a clear distinction must be made between trading venues where prices are formed according to transparent, non-discretionary and publicly known principles that reflect real supply and demand (exchanges and MTFs), and the other trading spaces. To that extent, it is not possible to consider broker crossing networks (BCNs) and therefore organised trading facilities (OTFs) as equivalent to regulated markets (RMs) and MTFs as they do not offer the same degree of transparency (and hence efficiency) of the price formation process. Crossing networks should at best be considered as an intermediate way to execute transactions, for residual transactions that do not constitute addressable liquidity or with a very strict ceiling above which those BCNs should be transformed into truly multilateral MTFs.

 AXA IM’s Head of Trading, Paul Squires, shares his thoughts on how the buy-side are preparing for MiFID II.

Liquidnet’s Seth Merrin shares how exchanges can develop a global strategy to compete today.

Following a year of failed crossborder mergers, exchanges are at a crossroads. They have worked in siloes within their respective countries but now have to create their global strategies. To move forward, there are lessons for the exchanges to learn from another industry that followed a very similar trajectory more than a decade ago—the airline industry.

Airlines share many parallels with exchanges—a strong nationalistic sentiment, a highly competitive environment driven by the entrance of low cost carriers, and a record of unsuccessful M&A activity. So what steps did the winners in the airline industry take in order to beat out the low cost competition, how did they achieve global scale and what can exchanges learn from this?

Airlines tackled the fundamental evolution of their industry by focusing on three key areas: diversification of revenue by selling more to their existing client base, differentiation of their offering by focusing on a premium customer, and development of global alliances to expand their geographic reach.

Let’s first take a look at revenue diversification and how exchanges can take a similar approach. Airlines realised they had a captive audience with their customers and once they had these customers in their seats, they could sell them more products. As a result, the airlines introduced paid-for services in coach and new premium products and services to all customers. Who hasn’t been on an aeroplane and paid for food, extra space, or, picked up an ever-expanding catalogue of duty free items?

Historically, exchanges have had two primary streams of revenue: company listings and trading. Today, these revenue streams constitute only a minor component of total revenue as exchanges have placed more emphasis on their ‘premium offerings’. The NYSE Euronext and Nasdaq, both of which have faced significant competition sooner than many of their peers, recognised that they had a captive audience in their listed companies and expanded their offering by selling premium services such as new technology offerings and premium data products and services. Today, both of these exchanges have multiple revenue streams and no single business comprises more than 20% of their overall revenue. What they have left to do—and what virtually no other exchange has done—is to develop a premium class of customer.

The entrance of low-cost providers, such as EasyJet and Ryanair, in the airline industry commoditised the price of an airline seat. As a consequence, airlines (particularly the established players) could no longer compete on price alone and needed to diversify their offering. So they went upscale, choosing instead to focus on high margins and higher value offerings, which their discount counterparts couldn’t match. While discount carriers charged for pillows, winning airlines created a premium offering and experience for their business and first class travellers. It’s not surprising that these premium passengers were willing to pay significantly more for steak, champagne, and lieflat beds because of the ultimate experience these airlines provided.

Richard Nelson, Head of EMEA Trading for AllianceBernstein, shares his perspectives on navigating volatility, prospects for developing exchanges, new regulation and the balance between transparency and best execution.

FIXGlobal: How much does volatility affect the way that you trade and what are you using to measure volatility on the desk?

Richard Nelson, AllianceBernsteinRichard Nelson, AllianceBernstein:
We use an implementation shortfall benchmark, so the longer we take to execute an order, the wider the range of possible execution outcomes. Volatility, in particular intraday volatility, increases that potential range, so you could see very good or very poor execution outcomes as a result. In reaction to that, we take a more conservative execution strategy or stretch the order out over a longer time period. And, for instance, if we get a hit on a block crossing network, we will not go in with as large a quantity as we would in a less volatile market. In that way we try to dampen down the potential effects that volatility might have on the execution outcome.

FG: How is AllianceBernstein using technology to improve performance and cut costs on the trading desk?

RN: It plays quite an important part and has done so for quite a while. We are pretty lucky in that we have a team of quant trading analysts. Most of them are in New York, but we have one here on the desk in London, and they help us to analyze the changing market environment and recommend the best ways we can adapt to it. Our usage of electronic trading has increased in the last year, we benefit from the quant trading analysts looking at the results we are achieving with our customized algorithms. We are more confident about getting good consistent execution outcomes because they are monitoring the process and making the necessary changes to ensure the results are what we are expecting. This, in turn, increases the productivity of the traders I have on the desk. They can place their suitable orders into these algorithms and let them run which allows us to focus on trying to get better outcomes on our larger, more liquidity-demanding orders.

On top of that, as market liquidity has dropped significantly, we are trying to make sure we reach as much potential liquidity as possible, and ideally we want to do that under our own name rather than go to a broker who then goes to another venue. We believe that going directly into a pool of liquidity is better done under your own name rather than via a broker because we can then access the ‘meaty’ bits of the pool rather than the ‘froth’. We are looking into ways of doing that but one of the problems is that, potentially, you get a lot of executions from a number of different venues, which results in multiple tickets for settlement. Our goal is to access all these potential liquidity pools, yet also control our ticketing costs, which are a drag on performance for clients.

FG: Was it an intentional change to increase electronic trading or was it a byproduct?

RN: It was a little of both. Our quant trader has been with us for two years and when he first arrived he had to sort out the data issues that exist in Europe and to clean things up. Once the data integrity was sorted out, we looked at different ways of employing quantitative analyses. Having somebody here who is constantly monitoring the execution outcomes means we can proceed down this path with real confidence. As a London firm, we were a little behind in our adoption of electronic trading, but now we are in the middle of the pack in terms of usage. It makes sense from a business and productivity perspective that there are many orders that do not need human oversight, which are best done in algorithms.

Lakeview Capital Market Services’ Peter van Kleef relates the state of high frequency trading (HFT) in Europe including which trades are overcrowded and where the next breakthrough will come from.

Is high frequency order flow in Europe coming from Tier 1 banks or prop desks?

High frequency order flow in Europe comes mainly from proprietary trading firms and hedge funds as well as bank proprietary trading desks.

How is MiFID II changing the mood for HFT? In particular, how will a consolidated order tape affect HFT traders?

High frequency traders were already using a consolidated order tape for their strategies, so the only difference is that MiFID II might make that data cheaper and more readily available. Also, having a consolidated order tape will improve transparency, but that may indirectly cause problems for prime brokers. For example, if a prime broker’s client sees a price in the market data, their execution partner might not be in that market or might not be fast enough to get the price that their client has seen.

What are the most popular instruments for HFT in Europe? Are there any favorite HFT trades that are becoming potentially too ‘crowded’?

Most people who are new to HFT, trade the most common items such as Eurostoxx, DAX, CAC, AEX, FTSE, Bund, Bobl Schatz Futures, etc. This is counterintuitive, however, as the new traders are entering the most crowded trades and most competitive products. There are crowded trades around Eurostoxx, for example, and as a result, there will always be mini Flash Crashes and disruptions of that kind. The real thing is not to keep people out of these trades but to set up better systems in the exchange to maintain liquidity.

People at buy-sides institutions are often uncomfortable with HFT in markets because they want to trade a large amount, yet they do so in a way that is evident to the market and especially to high frequency traders. If there is an impression that there is a buildup of pressure to sell, then traders will lower their price. Some may complain about this process, but it is not the fault of the high frequency trader. Buy-side institutions need to learn more about interacting with HFT in the market. Institutional investors will find that they enjoy more liquidity when they become more sophisticated in terms of how they interact with high frequency traders.

It is incorrect to view HFT as artificial liquidity. Volume is liquidity. It might not always be liquidity in the direction you want, but it is liquidity. It makes it easier to trade, but people are unfamiliar with how to interact, so they simply need to become more familiar with it.

What are exchanges and MTFs doing to attract HFT order flow?

Many exchanges are supporting volume discounts. Many of the new MTFs want to attract volume, so they offer volume discounts for HFT. If you provide liquidity, you are paid for that liquidity; if you take liquidity, you pay. This model is common in all industries. If you buy more cars, cars become cheaper; if you buy more shirts, they get cheaper. In addition, many new exchanges claim to be faster than their rivals.

On the other hand, the older more traditional exchanges have restrictions for liquidity providers and naked access, which is a  disadvantage for market makers who wish to interact with institutions or directly with exchange members. An unintended consequence of these restrictions is that by banning naked access, they disadvantage those very people they want to protect; i.e. the non members.

ITG’s Clare Rowsell and Rob Boardman outline the best practices for liquidity management across multiple regions, focusing on Asia Pacific, North America and Europe.

In an increasingly global and fragmented trading environment, finding and managing liquidity is the top priority for buy-side traders. The practicalities of doing so are complex, and are underpinned by the tradeoff between the time taken to find liquidity – which can result in delay costs as the price moves away, and the quality of that liquidity – trading against certain counterparties can increase market impact costs. Meanwhile, the global liquidity environment is changing rapidly due to evolving regulation, market structure and the trading tools available. What follows is a short summary of some of the most significant developments affecting liquidity management in different regions around the world.

Asia Pacific

Often cited as having a ‘last mover advantage’ in coming latest to the world of dark pools and alternative trading venues, Asia is now catching up rapidly. Growing awareness of the region’s higher trading costs (approximately one third higher than those of the US and UK) is creating market demand for both new lit and dark liquidity sources. Japan is the only major market that currently allows ‘lit’ or quote-publishing venues to compete directly with the exchanges, and in the past year market share on these venues (including SBI Japannext, Chi-X and Kabu.com) has risen, although they still average around 2-3% of total turnover.

Australia will be next, now that the launch of Chi-X to challenge the ASX exchange’s monopoly has been confirmed for early in Quarter 4 2011. As alternative lit venues develop, the importance of smart order routing grows and in Australia this has been a core component of consultation which will result in changes to regulation affecting brokers and exchanges and mandating Smart Order Routing (SOR) as a mechanism to achieve best price in a multi-market environment. For other Asian markets, buy-side traders have been turning to dark pools as a way of managing trading costs and finding quality liquidity.

Most of the large banks and brokers now offer a dark pool or internalization engine in markets including Hong Kong, Japan and Australia; but given Asia’s already-fragmented market structures, adding more broker liquidity pools threatens to complicate the buy-side trader’s life. This is where liquidity management, and specifically the aggregation of dark pools, is coming to the fore. Increasingly the buy-side are turning to dark pool aggregating algorithms to connect into multiple sources of liquidity through one access point.

Canada

Canada has long benefited from trading in an auction market supported by a highly visible electronic book. Even though it was not until the latter half of the decade that ATSs began to spring up in Canada, they quickly gained traction and in 2010 ATSs represented 34% of volume. As these changes have taken place, Canadian regulators have continually reviewed emerging regulation in other regions as Canada continues to parallel more mature markets. With the proliferation of alternative trading venues came an emphasis on the consolidation of data to ensure market integrity. In addressing the need for a consolidated tape, the CSA accepted RFPs and appointed the TMX Group to the role of Information Processor.

Also arising from the multiple-market trading environment is Reg.NMS-style regulations to protect against trade-throughs. February’s Order Protection Rule shifted the best price responsibility to marketplaces and also requires full depth of book protection (unlike the US’s top of book protection). About 3% of Canada’s equity trading is done in dark pools, and although Canada has only two dark pools (Liquidnet Canada and ITG’s MATCH NowSM), Instinet plans to open two this year and Canadian stock exchanges are making moves to offer dark order types.

In this article, Equiduct Trading’s Joint CEO Artur Fischer argues that in times of extreme structural and economic change, there is an even greater requirement for transparency. He believes that in an increasingly fragmented market, there’s an even greater risk that organisations will need even more help if they are to avoid effectively trading in the dark with no clear consolidated view of market pricing. Here he identifies the growing requirement for a new generation of virtual order book that can consolidate all the visible pre-trade information generated from significant relevant markets, effectively delivering transparency and providing firms with access to a single, unbiased source of pan-European equity price data.

The European equity markets have undergone a period of rapid and unprecedented change over the past two years. While some of these shifts have been mainly related to the still-evolving current global economic situation – leading to the disappearance or restructuring of some of the biggest names in finance – others have centred around newlyintroduced regulation, with the arrival of new types of execution venues and cross border clearing venues being among the most obvious and significant.

These changes have created some huge challenges (and it should be said equally huge opportunities) for market participants, whether they be the large broker dealers having to connect to all the new trading venues in search of liquidity, or a pension fund simply trying to understand what the “Best Execution” he has been promised actually means.

Each of the incumbent Exchanges, the new Multilateral Trading Facilities (MTF), and the growing number of Dark Pools or Crossing Networks provides an alternative USP for execution of equity orders, and each operates with a slightly different business model - both pre and post trade. This has understandably stimulated competition for order flow liquidity, introducing alternatives in the post trade space, and leading to a major shake up in fees. Not surprisingly, this has also irreversibly fragmented liquidity. However, this fragmentation is an evolving process; the picture is far from complete or even stable, and can be expected to go through several consolidation and subsequent fragmentation phases before the next “Big Bang”.

Opening up the European equity markets
With new entrants into the execution space, Europe’s equity market is opening up for investors from across the world. FIX-compliant technology is enabling easier connectivity to the new venues and providing an opportunity for a wider range of firms to get access to venues over and above the incumbent. In Vol 2 Issue 8 December 2008 of FIXGlobal, John Palazzo of Cheuvreux stated “FIX affords every broker the ability to get into these markets at an unprecedented pace” – at Equiduct we certainly agree, but there are still some considerable challenges.

How, for example, do “sell-side” firms determine whether they should connect to these new venues? How do they then prioritise which to connect to? How do they choose where to actually send their order? Also, how do “buy-side” investors understand which venues their brokers should be connected to, if they are to ensure them the mythical Best Execution? What price should they be using to markto- market at the end of each day and for intraday position risk purposes?

At Equiduct, we’re hoping to provide some of the answers to these important questions. We hope to be able to shed some light on the situation and show how to achieve best execution on the various available platforms with a range of analytical tools. Uniquely, the toolset includes a Pan-European aggregated feed.

Ensuring execution on the most appropriate platform
Firms across the trading spectrum, whether small or large, are increasingly using sophisticated smart-order-routing solutions and algorithmic trading systems to “slice” orders and to determine where they should distribute the pieces across the Dark Pools, MTF and Exchanges. However, in order for these systems and indeed an individual trader to start to effectively predict the future, it is important to understand the present and the past. Information providers such as Markit or Fidessa with their Fragmentation Index can confirm the common knowledge that liquidity fragmentation is a reality once a trade has been executed. However they do not have the ability to see how the market should have performed by examining the pre-trade order and price information that was available at the time of trade.

At Equiduct we have been collating all visible pre-trade information (Level II data) for the top 700 shares across Belgium, France, Germany, The Netherlands and the UK from the major European venues (BATS, Chi-X, NYSE Euronext, London Stock Exchange, Nasdaq OMX, Turquoise, Xetra) since April 2008. Yes, a significant percentage of order flow has moved away from the incumbent exchanges but what is not such common knowledge is that trades are still not always executed on the most appropriate platform. Indeed our analysis shows that in April 2009 a significant proportion of trades executed on the incumbent exchanges should have been transacted on an alternative venue, and approximately 35% of executed trades are still not transacted on the best price venue. Significant price improvement could have been achieved if this had happened. (See Diagram 1)

The way