Although the clamour for transaction cost analysis (TCA)
tools is growing amongst buy side firms, they face numerous challenges if they
are going to use them effectively, said panelists at Profit & Loss’ Forex Network New York conference.
“Best execution has never been more in focus, and there are
two main reasons for this,” said Mike Harris, president of Campbell &
Company. “Number one, because of the heightened sensitivity around the
regulatory environment, and number two, because finding alpha opportunities in
the market right now has become more challenging.”
He added that in an environment in which trading strategies
are producing 15-20% returns, there is less focus on slippage, but now that
many of these firms are instead managing closer to 200-300 basis points, then
the attention inevitably turns towards finding ways to make their execution
This is exacerbated by the current market environment in
which more trading firms are using shorter-term models, meaning that they are
putting through more transactions. As a result, transaction cost becomes more
Buy side firms though, said Maria Prata, managing director
at Deutsche Bank, are increasingly concerned about market impact rather than
just the price of their transaction.
“What we talk about today with clients is much more focused
on execution style and how the client wants to design their execution platform.
The conversation is less about spreads, which was the main focus for clients
about five years ago, and more about market impact.
“It’s about understanding what is happening to your trade
information after you execute, what kind of liquidity pool you have and the
compatibility of your liquidity pool rather than just getting three prices and
making sure that you meet the set benchmark. So now we’re having much more
detailed conversations with our clients and using TCA to validate what the
execution was supposed to do in the first place,” she said.
TCA is widely touted as a tool that can help firms analyse
their trading patterns and find better ways to trade, but the panellists
highlighted that to actually use TCA effectively is not an easy task.
“There are a lot of challenges for individual firms to get
value out of TCA,” said David Mechner, CEO of Pragma Securities. In particular,
he noted that accessing meaningful reference prices and high quality data to
use in conducting TCA as two major difficulties facing these firms.
Mechner added: “But one of the difficulties that I don’t
think gets focused on enough is that individual firms face a huge challenge
with just not having enough data to do a meaningful analysis.
“Every firm wants to behave as though TCA can tell them
something meaningful, but in many cases they just don’t trade enough size or
consistently enough to get meaningful results that will let them judge how
they’re performing. There’s a gap right now between what people want from TCA
and what they can get out of it.”
The flipside of this problem is that banks and other large
financial institutions have so much data that it can prove challenging to sift
through and present it in a manner that helps with pre-trade TCA.
“Navigating through the sheer volume of data is a challenge
for all the banks. But done right, it should help clients get better execution
rates and banks manage risk better. We are using technology stacks developed
for social media to help us,” said Mauricio Sada-Paz, co-head of EMEA FX sales
and global head of e-FX sales, at Bank of America Merrill Lynch (BAML).
To emphasise the scale of the data the banks are processing,
Sada-Paz pointed out that BAML’s e-FX spot business alone can processes almost
4 billion messages daily. To put this in perspective, that is five times more
than Twitter is thought to process each day.
Choosing a benchmark
But although managing all this data can prove tricky, Prata said
that there is a direct correlation between the amount of data that the banks
can collect and the effectiveness of their TCA.
“The more data we have, the better it is for us. But it’s
about ensuring that we get that information into a format that makes sense.
Clients want to talk about liquidity, not only in a historical way, but also in
real time in order to get more colour on what’s happening not only with the
prices, but behind that. So the challenge is around using that data and being
able to manage all that data, but these are challenges that all organisations
face,” she explained.
Another issue addressed by the panellists was the need to
pick the right benchmarks when conducting TCA.
While Mechner claimed that “using a bad benchmark can be
very harmful”, Sada-Paz said that a bad benchmark can render TCA largely
irrelevant, commenting that “a bad benchmark can make even the worst strategy
“The Fix is a great example where you can define a
benchmark, which is a reference price, but then when you give a mandate to a
trading desk that they’ll be judged against it, it ends up costing them a lot
of money. So TCA is not valuable if you’re looking myopically at an arbitrarily
defined shortfall relative to a benchmark and then hiding behind this,” said
Meanwhile, Harris claimed that the scandals around the
London 4pm Fix have “really changed the best execution landscape” by forcing
real money firms to re-examine their execution processes and ask more questions
about how benchmarks are used as a metric for best execution.
Empirical data required
This general question around benchmarking was picked up on
by Petra Wikström, global head of FX execution and alpha solutions at BNP
“A large part of the discussion in the TCA space is about whether
the right benchmarks are being used for the right reasons and then whether
firms are drawing the right conclusions from those reports,” she said.
Wikström said that the discussion around which benchmarks to
use is part of a more macro-focused discussion of TCA. However, she adds that
there is a parallel conversation going on that is more micro-focused and where
there is a growing demand for tools that will provide firms with a better pre-trade
understanding of the market impact of their trading strategies.
“Specifically, when it comes to market impact we see demand
from investors to estimate and compare that of real products, given the current
liquidity conditions. This analysis naturally demands large amounts of
empirical trade data to support such a quantitative estimation of the market
impact,” Wikström commented.
Ultimately, the comments from the panel illustrated that buy
side firms are becoming increasingly sophisticated in both their understanding
of what constitutes best execution and the role that TCA can play within that,
which is certainly a positive development for the FX industry, not least
because TCA itself remains a challenging tool to implement effectively.
Or as Mechner put it: “There’s no escaping the fact that it
takes a lot of thought and intelligence to extract value from TCA; it’s not a