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The high price of failure to determine cost per trade

By Jonny Speers, Global Head of Sales, Torstone Technology

Trading costs have long been cited as a pivotal evidence in determining the profitability – or lack thereof – of a trading desk, but new regulatory pressures mean the metric is becoming an increasingly important factor in establishing and adjusting overall firm strategy. New European penalties expected to come into effect in February of 2021 will result in stiffer penalties for trades that fail to settle on time, changes that the International Capital Markets Association estimate could cost billions. Additionally, trade processing costs are likely to increase once the Settlement Discipline Regime (SDR) under the Central Securities Depository Regulation (CSDR) comes into effect, early next year, introducing fines and mandatory buy-ins for trade failures after a fixed time period. 

For asset managers and other firms aiming to avoid steep cost hikes by keeping ahead of these and other industry movements, it is paramount to have an accurate, comprehensive understanding of their own trading costs. However, new research from Torstone Technology indicates up to 67 percent of firms are unable to cite a total cost per trade.

Torstone surveyed 126 firms and found that of the minority of firms that could report a cost per trade, most were processing an average daily volume of 100,000 trades or more across all asset classes. The reported costs varied greatly and were affected by characteristics such as the over-the-counter (OTC) vs. exchange-traded nature of the instruments. 

This poor overall awareness of trading cost is directly related to the complex set of processes that constitute a trade, with explicit and implicit trading costs, as well as post trade processing costs, presenting challenges in determining a clear cost per trade.

Explicit costs charged by counterparties, agents and marketplaces for engaging in a trade seem self-explanatory but are not always clear. For example, OTC instruments such as bonds may be traded on a spread rather than on a fee, and the counterparty will take part of that spread as their return for the engagement without identifying their cut. 

Implicit costs also decrease transparency. For example, any delay to a trade’s execution may see prices move against the trader, creating a facilitation shortfall. If a broker takes on a large trade for a client and other brokers learn of the trade, they will be able to trade against that position and push the price up or down against their rival.

Finally, post-trade costs can have a considerable impact on the overall cost per trade; settlement and clearing charges, plus any requirements to post collateral for trades that require margining, all add to the total cost and need to be included in the assessment of trading expenditure. Post-trade costs are clearly tied to explicit costs and the internal costs of that processing. Bringing the explicit post-trade costs into the overall equation for trading expenditure will allow trading heads to assess their operations holistically in order to locate inefficiencies and iron them out. 

Decreasing this opacity allows business managers to identify potential cost savings or efficiencies in processing, which in turn create real opportunities for sell-side and buy-side firms to improve the margins they generate on the back of trading and investment activity.

Analysis of trading costs in the front office is increasingly important, now that buy-side trading has been separated out as a cost centre under MiFID II. Equity markets use transaction cost analysis (TCA) models to estimate the impact of explicit and implicit trading costs. Applying these measures in the fixed income and other OTC markets is more challenging, as they assume a security’s price is the key measure of execution quality, when for less-liquid instruments, speed or filling an order may take priority.

For both banks and asset managers, getting a grip on the processing of trades is only possible if their systems can aggregate a full view of transactions, including all of the stages from execution to settlement, a process made very difficult when using multiple, legacy systems. Additionally, consolidated data from different platforms increases operational risks and increases integration costs.

Based on Torstone’s research, it is evident that the required level of trading cost transparency is not yet being realised by many capital market firms. Not only will this opacity have implications for establishing the operational costs of trading – which are fundamental to analysis of operational efficiency – but also the pricing on offer to clients, which impacts the competitiveness of the firm’s trading operations. This will be most apparent when placing complex trades or instruments, where multiple legs are involved, or margining is required. 

According to the recent analysis by Coalition, margins have declined across the investment banking business by 500 bps in 1H19, reaching the lowest level in the last four years. Offsetting these declines will demand greater transparency around cost and profitability.



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