27 March 2012 | Volume 3 | Issue 6

The Blotter presents ITG’s insights on complex global market structure, technology, and policy issues.

Contributors

Yossi brandesManaging Director, Head of ITG Analytics in EMEA Yossi.Brandes@itg.com+44.20.7670.4226

ian DomowitzManaging Director, ITG, and CEO, ITG Analytics, Inc. Ian.Domowitz@itg.com+1.212.444.6279

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Asia Pacific +852.2846.3500

Canada+1.416.874.0900

EMEA+44.20.7670 4000

United States+1.212.588.4000

info@itg.com www.itg.com

transaction Cost analytics in Europe:the London/Paris Divide and Where they Meet. ITG’s team of experts survey 48 respondents in Europe to better understand perceptions and realities related to TCA usage.

When digging into the details of trading performance, no one likes one-to-one conversations like we do. When searching for the wisdom of crowds, you need a crowd. Markets operate on this principle.

So, we also like surveys, especially in the area of transaction cost analysis (TCA), where standardization is not a term in the data dictionary. Firms such as Aite, Tabb Group, and Greenwich Associates all are active in the area. Sometimes the results are insightful (compliance usage is shrinking relative to desk performance mandates). Sometimes findings suggest a clear misunderstanding (the equating of TCA with VWAP performance). And occasionally, we just laugh (a ‘thoughtful and powerful critique of TCA as a tool’ is summarized by, ‘more non-traders are looking at TCA and this is a very bad thing’).

The usefulness of survey evidence lies in the questions, of course, and in the sample of respondents. We recently went looking for questions and a suitable crowd in Europe. Some informal discussion yielded some simple, yet interesting, questions. Simple avoids ambiguity in responses, and we are certainly not pros in the survey space. Seminars on trading performance in London and Paris gave us a crowd; 48 respondents, anyway, of whom 44 are actively involved in TCA of some form. This is a decidedly selected sample, and by choice: we are interested in what practitioners think, as opposed to a random sample of traders, for example.

We begin with TCA usage, summarized in the first figure. All charts contain results aggregated across the Paris and London respondents. We discuss their differences as we go along.

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2tHE bLottEr | 27 March 2012 | Volume 3 | Issue 6

Figure 1

Source: ITG

The relatively heavy weight on broker performance echoes a recent Greenwich Associates study, in which it is reported that 40 percent of respondents use TCA for this purpose.1 Similarly, compliance usage is down in percentage terms relative to published 2010 data. Most interesting, however, is the strong showing of TCA in the context of coordinating portfolio manager orders with the buy-side trading desk. We also have seen this development in the U.S.

The aggregate results hide significant differences between London and Paris. French participants find broker evaluation to be more important than their London counterparts (42 percent versus 24 percent, respectively). London sees portfolio manager communication to be the most important use, at 38 percent. In contrast, communication with external clients is highlighted in Paris, but dialogue with portfolio managers garners only one positive response.

Given our own experience with portfolio managers and TCA in the U.S., we asked about the nature of manager usage. Those results are illustrated in Figure 2.

Figure 2

Source: ITG

1 Greenwich Associates, TCA: Taking the Next Step, survey based on 2011 data.

33%

18%

23%

28%

Evaluate Brokers

Compliance

Dialoge with PMs re cost of implementing a portfolio

Other Usage *

TCA Usage

Other Usage included; Traders' performance, General Performance and reports to external clients

48%

16%

35%

Portfolio Construction

Reporting

Not at all

PM Usage of TCA

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The heavy weight on portfolio construction is largely due to the London contingent. This is consistent with the previous result on general usage, and follows empirical evidence as to the benefit of coordinating trading tactics with portfolio strategy.2 Reporting includes information to investors and fund boards, and the numbers are small. We see a great deal of board reporting in the U.S., but these efforts typically are driven by the buy-side trading desks, as opposed to portfolio managers. The glass is clearly half full along the portfolio manager dimension; we were pleasantly surprised by finding that almost two-thirds of the respondents noted manager involvement in trading performance processes.

Returning to the trading desk, we ask whether TCA is an integral element in setting trade execution policy.

Figure 3

Source: ITG

Execution policy is mentioned in MiFID as part of a structured approach to best execution. While the definition of policy remains vague, it seems clear that broker, routing, and venue evaluation should be considered. Viewed in the context of MiFID, the 20 percent voting ‘no’ is puzzling. Conversations with individuals produced definitions roughly in line with such guidance, but additionally ranged as far as the choice of algorithmic trading strategies. We might have explained this a bit better during the seminar sessions. Nevertheless, the responses may be interpreted as validating survey evidence in the U.S: TCA is no longer just a compliance tool in Europe. This is particularly true in London, where 83 percent answered ‘yes’ to the question.

The selection of TCA benchmarks is a controversial topic, showing the least standardization across buy-side firms. Some aggregate numbers appear in Figure 4 on the following page.

2 Transaction Costs and Equity Portfolio Capacity Analysis, Yossi Brandes, Ian Domowitz, and Vitaly Serbin, in Bernd Scherer and Kenneth Winston, eds., The Handbook of Quantitative Asset Management, Oxford University Press, 2012; Portfolio Optimization and the Cost of Trading Milan Borkovec, Ian Domowitz, Brian Kiernan, and Vitaly Serbin, Journal of Investing, Volume 19, Number 2, Summer 2010. Reprinted in, The Journal of Investing’s Most Popular Articles of 2010, Institutional Investor Journals, January 2011

73%

20%

7%

Yes

No

Don’t know

TCA & Execution Policy

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Figure 4

Source: ITG

Implementation shortfall can include a spectrum of decision price benchmarks, while ‘Volume’ includes VWAP variants, including price-weighted participation, or PWP. Leaving the finer points of using multiple benchmarks aside, the aggregate results mask an important difference between Paris and London. French desks appear to rely heavily on volume participation measures when giving instructions to brokers and then scoring them; 52 percent fall into this category. The British rely on permutations of the implementation shortfall benchmark, a measure of pounds won or lost due to frictions in the trading process. In London, 55 percent of respondents use implementation shortfall as a primary measure.

We occasionally see a link between primary benchmarks and the frequency of TCA reporting. When observed, the link often is traceable to the ability to capture relevant market data to calculate certain benchmarks at high frequencies. We did not try to pose a question at such a level, but did ask about reporting frequency. The results appear in Figure 5.

Figure 5

Source: ITG

44%

39%

17%

Implementation Shortfall

Volume

Close

Benchmark Selection

16%

9%

41%

34%

Real Time

T+1

Weekly, Monthly, Quarterly

Mix

Reporting Frequency

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Reporting frequency refers to the times reports are delivered by a vendor to the buy-side firm. Despite a great deal of discussion surrounding real time TCA in the industry, usage is light. Even next-day reporting is scarcely used, unlike the U.S. experience. The small numbers are mostly due to London behavior, however. In Paris, participants exhibit a 21 percent use of real time information, and another 13 percent analyzes performance immediately post-trade. The aggregate 34 percent far outweighs the London experience, where only 10 percent report real-time analysis, and another 5 percent receive next day reports.

Finally, increasing chatter surrounding multiple asset classes prompts a question with respect to the next asset type deserving performance analysis.

Figure 6

Source: ITG

We forgot to ask about options, but this is the set of asset types for which there is some vendor provision of TCA service in Europe, outside of equities. In this category, Paris and London agree completely: you can flip a three-sided coin. The forced ranking of the question seemed appropriate to us, but our conversations with respondents suggest that all asset classes deserve attention as the markets evolve.

Despite the coin flip, and the shortness and simplicity of the questionnaire, we learn some interesting things here, and can deduce some others.

• Compliance use of TCA appears to shrinking relative to trading desk applications, validating results from the U.S.

• There is growing portfolio manager involvement in trading performance, driven in part by the consideration of implementation costs in portfolio construction decisions.

• Benchmark bias appears to have regional roots, despite the growing interdependence of trading in the European marketplace.

• Broker evaluation tops the charts with respect to the use of performance statistics by a trading desk.

This last item is complicated, because there is a variety of dimensions along which brokers can be judged. High-touch performance is bundled with

35%

29%

35%

Futures

FX

Fixed Income

Next Asset Type

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algorithmic trading prowess in such comparisons, for example. It would make sense to see real-time TCA usage as an integral part of making destination decisions, but we see relatively little use of this capability, especially in London. There is a reason for this, however.

TCA should provide real-time assessments, but meaningful results for brokers or algorithms, for example, must be set in the context of robust data over periods of time. An alternative perspective on TCA can take shape, however, if one abandons the dividing line between post-trade historical analysis and pre-trade strategy selection and monitoring.

The key to this development is delivery of information from post-trade TCA performance data to pre-trade tools, based on the blotter’s orders and tuned to decision making. An order’s characteristics are enhanced by performance information given current market conditions, permitting broker evaluation and strategy analysis. From the perspective of post-trade analysis, we move from T+1 to real-time. Viewed from the pre-trade perspective, market data is complemented by data based on execution history. A proactive approach to best execution becomes possible, informed by previous performance characteristics and enabled throughout the life of the order.

Although survey results here and elsewhere suggest that compliance use of TCA is falling in percentage terms relative to trading process improvement, this development is more nuanced in Europe. We have already noted that ‘execution policy’ may have a compliance interpretation in the minds of some respondents. The combination of the new Market Abuse Regulation (MAR) and the Markets in Financial Instruments Regulation (MiFIR), sometimes called MiFID II, aims for a far reaching Europeanization of capital markets law. Uniformity of language and extensive cross references between regulations suggest that requirements, including best execution, would be harmonized at the European level. Best execution requirements will drive compliance duties across a broader range of financial instruments, venues, and processes within investment firms. Broker evaluation rises even higher on the list of priorities for TCA. At the level of the trading desk, pre-trade and post-trade TCA are beginning to be employed for the analysis of order routing, venue-type selection, and strategy performance, relative to investment objectives. Surveillance requirements pursuant to the MAR may finally rationalize pan-European data.

In hindsight, we should have queried the crowd with respect to a consolidated tape. The rationalization of data ascribed above to regulatory surveillance is a necessary piece of standardization. A consolidated tape would be an important first step, harmonizing post-trade market data in such a way as to make it easier for compliance departments to use TCA as a tool, for example. Greater depth of standardized post-trade transparency also improves the ability to analyze how brokers and routing technologies source liquidity and manage trading. If this came to pass, the Paris/London divide may even narrow.

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