Too many people use a narrow definition of transaction cost analysis (TCA) in foreign exchange trading, according to research company, ClientKnowledge. This just looks at the bid-offer spread, or the price of execution, instead of looking at the full cost of the trade.
Justyn Trenner, CEO of ClientKnowledge, says: “Properly used, TCA should take in the wider definition, looking at the full cost of doing a trade. This takes into account market impact and cost settlement, as well as price. However, the majority of people we speak to use the narrower definition. It is a poor use of TCA.”
He says the reason for this is that the people who use TCA have their performance benchmarked against the success or otherwise of the trade, rather than the cost of running the business.
There is a growing role for TCA in determining best execution of FX trades. The main reason for this is upcoming regulations that require proof of best execution – for example, the Markets in Financial Instruments Directive (MiFID) and similar regulation in the US.
The main tenet of best execution in MiFID is getting the best overall deal for the client and the optimal result for the client portfolio. MiFID does not affect the spot FX market directly, but it does expect investment firms trading in every asset class to make the best use of the FX market when making a trade that involves exchange of currencies. Investment firms will have to find the best deals for their clients, and that will involve not just the price of the asset on the trading screen but also the cost of clearing and settlement and the cost of FX.
Mr Trenner says: “Used effectively TCA allows investors to understand their full cost of trading. This means not only the price, and spread and skew in the price that they achieve, but also the full cost of settlement against that trade.”
It also allows them to benchmark their performance against different providers and venues, against times of day and in different instruments and currencies, he says. This will give them intelligence from their own activity that they can then use to get better FX returns. “So it has a housekeeping role, but for certain types of asset manager TCA can also help provide alpha.”
Richard Estes, head of e-commerce for global markets, Bank of New York, agrees that, if used properly, TCA should show that the investor is achieving best execution.
He says: “It helps minimise any perceived slippage in trading FX. As FX is not traded through an exchange, there is not a single price at any given time. There could hence be slightly different prices from different providers. In the past when investors were making significant gains from their securities, FX execution was not scrutinised as closely. Now that investment returns have moderated, investors are looking for other ways to add to total return, including how their FX trades are executed.”
However, Mr Estes agrees with Mr Trenner that there is too much emphasis on price in best execution. He says: “Other factors determine best execution. They can vary depending on the market you are investing in. For example, when trading for an account that is kept by a custodian, if you trade the FX away from the custodian, there may be third-party fees that have to be factored into the overall cost. Also there is the potential cost of trade failures, which should be factored into the overall cost.”
However, he adds: “I’m not sure if there is a proper model for evaluating all these different costs in order to determine best execution. There is no clear definition of best execution in the FX industry. MiFID has produced something, for example, within the securities market, but has not taken a specific position regarding FX. It is still a grey area.”
Chip Lowry, senior managing director, State Street Global Link, Europe, points out that MiFID’s definition of best execution includes many different factors such as: price, cost, size, speed, likelihood of execution, likelihood of settlement and nature of order.
He says: “TCA is a tool in the toolbox. I would be very concerned if people looked at it as their definition of best execution. Everyone will tell you that. The only people who won’t are the ones who own a portal where everything is competitively priced.”
And even if it were just about price, it is hard enough in FX to show that you had found the best one.
Jonathan Butterfield, executive vice president, CLS Bank International, says: “FX is tough to tie down, because prices change second to second. That would be okay on an exchange but if you are looking across four platforms, they are not in synch. What is the price at an exact moment in time? Nobody knows.”
One increasingly popular solution to this problem is the use of benchmarks.
Mr Estes says: “Some investors want to ensure that they receive a fair and transparent price from their FX provider. This has increased interest in benchmarking.
“Investors may ask an FX provider to demonstrate that the rate applied to a trade is reflective of the market price at that time. One way of doing this is to base the trade’s pricing on an independent reference rate that can easily be verified by the investor.”
There is also a growing use of benchmark execution by investors - the option to execute trades at a fixed time each day, via an independent rate. The rate could be supplied from the WM Company or the Bank of England. Some banks also offer their own fixing rates.
State Street’s Mr Lowry agrees. “There is a role for benchmarks,” he says. “Best execution, in addition to those eight MiFID criteria, will mean different things to different people. If you are an investment manager who relies on your custodian to do the trade, then you have to do it at a benchmark. That could be best execution.
“If you use an index fund tracking the WM rate, then you only worry about slippage in the WM rate. That could be best execution. It’s situational.”
