TORA’s Software Director Pascal Kuyten writes about changes in how asset managers and hedge funds use Transaction Cost Analysis (TCA). Spurred by regulatory change and the emergence of new artificial intelligence (AI)-powered technology, it has evolved from being an after-the-fact, report card-type exercise to one of the highest and most informing trading and investment decisions in real-time.
30 Years of TCA
In the mid-1980s, asset managers began using post-trade TCA to determine which of their brokers were executing their trades for the lowest total cost, mainly using the volume-weighted average price of their transactions as the benchmark. Managers typically received their reports monthly and were left to compare those reports to determine which brokers would be the most cost effective to trade with in the future. Independent third-party providers such as Plexus Group and Elkins McSherry came upon the scene in the late 1980s and early ’90s and took TCA up a level in helping firms with this analysis.
The science and practice around TCA continued to evolve at rapid pace over the next decade, as managers were now able to clearly see how minimized trade execution costs translated into additional basis points of performance for their funds. With this understanding, managers looked to identify and reduce all explicit and implicit costs. This included delay costs and opportunity costs that took into consideration the time it took to implement an investment decision and whether a different decision would have produced a better result.
Fast forward several more years and new regulations such as MiFID II added an additional impetus for firms to adopt TCA analysis. MiFID II requires asset managers by law to take “all sufficient steps” to achieve best execution. So what does this really mean? Well, best execution is now typically determined based on total consideration; this includes not just the price of the financial instrument and the costs of trading it, but also all the ancillary costs, including those such as execution venue fees, clearing and settlement fees, and any other fees paid to third parties involved in the execution of the order.
Running parallel to this evolution has been the emergence of new TCA tools that enable the buy side to analyze performance on a pre-trade and intra-trade basis. These tools, which are often powered by AI or machine learning technologies, take into account myriad real-time data points to help traders determine if they are garnering best execution for their orders by monitoring costs along the lifecycle of the trade.
TCA in Action
While the introduction of the more stringent MiFID II regulatory framework has been a catalyst for firms to find better ways to measure trading activity, it has also served to formalize many processes that were already taking place across many corners of the institutional investment industry.
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