In this week’s Buy-Side Perspective, JOE COLLERY, head of trading at Comgest, discusses the crucial role that TCA plays throughout the trade lifecycle – and how to leverage it successfully in an ever more fragmented marketplace.
MiFID II has led to increased regulatory requirements for firms, most notably an important focus on best execution. TCA (Transaction Cost Analysis) has become an important tool in the performance analysis and cost measurement of trade executions. This article describes the methodology behind TCA throughout the entire lifecycle of a trade, from the pre-trade phase to its successful settlement.
Today’s market has become increasingly fragmented, requiring firms to not only access these new trading venues but to measure their validity from a best execution point of view. The first challenge is of a technical nature, ensuring robust applications are in place supported by a strong IT infrastructure. The sheer volume of data is imposing and needs to be organised and interacted with in a meaningful way. It is imperative that the systems in place be nimble and flexible to represent the data from multiple angles.
Increased focus on best execution
TCA is an ever-important tool for trading desks globally, with further regulatory requirements and reporting capabilities deemed fundamental to its application. Execution analysis must be clear, coherent, and transparent in nature and available to all departments across the business. It is an important window into how financial trading data can be represented in a sophisticated, measured way.
The increase of regulatory focus on best execution has led to an increased level of transparency across the industry as well as a proliferation of performance measurement tools and applications. An increasingly popular model has been a centralised database with a multitude of benchmarks, all relevant timestamps and all execution venue data contained within. This allows for each individual department to interact with the data based on its own requirements, whether that be the trading, compliance, client reporting department etc. The flexibility and versatility of the database allow for reporting to meet specific department needs.
Traditionally the Broker Review was an in-person process with limited data available for presentation. Reports of a static nature were analysed detailing the quality of the trading activity and the level of service provided by the broker in question. The global adoption of a remote working environment brought about by the propagation of COVID 19 transported this traditional in-person review into an online appraisal. This enabled both parties to share enormous amounts of information in a real-time environment that would not have been previously available in person. This deep dive analysis of the data has created a new level of transparency, understanding and improvement of the direction the industry would like to push towards – first-rate execution prices for the end investor.
Enhanced methodology
Traditionally TCA tended to analyse execution details once the trade had completed. It was quite a retrospective process where relevant benchmarks were downloaded from the primary exchanges and trading performance was evaluated. In this era of the proliferation of data and multiple execution venues, performance analytics begins right at the idea conception on the portfolio manager side of the business and can be broken down into three distinct stages:
Stage One: Pre-Trade
Once the decision has been taken by the investment team to place an order the performance clock theoretically starts ticking. This trade will have an order generation time stamp and from this point forward performance can and should be assessed. An important part of the pre trade process is the evaluation of what is often referred to as the estimated impact cost. This figure, expressed in basis points, is a useful guide to the trader to aid in making an informed decision on the trading strategy to execute the particular security. There are a number of metrics taken into account to arrive at this figure including percentage of ADV (Average Daily Volume), volatility, historical performance, momentum and spread capture, to reference but a few.
To further enhance the execution strategy an analysis can be performed on the available liquidity pools including block venues and dark pools. Essentially the strategy is to enrich one’s decision-making toolkit with as much available information as possible to provide the best possible outcome. Armed with this mass of information the trader is in a position to commence a fully informed execution of the trade with considerable insight.
Stage Two: Intra-Trade
While intraday trading is traditionally quite reactive in nature, as relevant market information from multiple sources is digested by the participants and reflected in the price, today’s technology enables traders to be more proactive. Trading parameters including venue opportunities can be adjusted instantly at the click of a button. Real time data analytics aid the trader to evaluate market conditions, potential trading impact and execution performance versus the expected outcome from the pre-trade stage.
A prerequisite for this functionality of course is a powerful EMS (Execution Management System) equipped to display this information in a meaningful, easy to use manner. In a world of continual disruption, more and more technology companies are challenging existing trading systems making it more user friendly to monitor the depth and breadth of market information. This is a crucial development in today’s markets where ease of use and “1-click” style processing, patented by Amazon back in 1999, are a prerequisite for the majority of users. Systems must be robust, responsive, and reliable allowing effortless mouse clicks to perform complex strategies in a compliant way.
The key challenge for these providers is to respect the regulation for each jurisdiction in which the system will provide access. This requires a robust support infrastructure with client specific customisation and compliance/risk oversight. As regulation tends to evolve in order to improve market transparency and best execution requirements, accordingly the system will be immediately adaptable to these updates. This requires an open architecture with system and data interoperability and strong cloud computing infrastructure.
Stage Three: Post-Trade
This is perhaps the most data intensive stage of the trading process. On a post trade basis there are colossal amounts of data that must be downloaded and stored in an easy to access database environment. It is from this central repository that all relevant teams can access trade history for their reporting and analytical needs.
Compliance teams can monitor trading activity in myriad ways as well as setting up outlier and specific trigger alerts that are automatically sent to their front-end tools for review and investigation where appropriate. Investor facing teams can also run client specific reports detailing all relevant information from trading volumes and trends to execution performance.
Interaction with this data from the trading desk is of fundamental importance. The trading performance obtained from this treasure trove of information will bolster the pre-trade phase and the cycle recommences its circular motion (figure 1).
There has never been a more exciting time in the area of technology intersecting with financial information. Traders are now equipped to make informed judgement calls on the back of easily digestible data fed through sophisticated avenues. This promotes better risk management and decision making based on real time improved tailored data feeds. It is an essential function of the minimum estimated cost for the acceptable level of risk.
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