Gauging Trading Costs

Terry Flanagan

A clear metric of the cost of trade is essential for banks to decide which products and which customers are additive to the bottom line, and which need to be removed from portfolios.

“The cost to trade incorporates four main elements,” said Tom Roughan, a partner in the capital markets practice at consultancy Capco. “It’s the front office, middle office, back office, and then the fourth is the external cost to trade, so it’s encapsulated in brokerage clearing and exchange: what the large banks are paying to those providers for clearing, trading, selling trades.”

Measuring the cost of trade is very difficult “because there’s so many different factors, so many different reference data problems inside the bank, so many different financial allocations that skew a bank’s understanding of what their true costs are,” said David Oxenstierna, head of the North American capital market practice at Capco. “The measurement problem is very non-trivial.”

The real value of measuring cost to trade lies in behavioral modification “with traders in how they select, for example, which broker to do business with, their understanding of collateral trading costs, financing trading costs,” said Oxenstierna, a former operational executive at Morgan Stanley. “Investment banking is one of those industries which are remarkably poor in general at understanding which clients are truly profitable and which are not profitable.”

Stitching together the complex components needed to construct a complete view of trade costs remains a considerable challenge for most banks.

“Banks are very complex, so there’s a large number of technology applications in use across front, middle, back office to support the process of calculating cost to trade,” Roughan said. “There’s all the compensation for the staff and all the internal inter-company allocations that go into those calculations as well. Another piece of complexity is that each product has its own trade lifecycle in terms of when are you going to trade it, when are you going to clear it, when are you going to settle it.”

Transaction costs can range anywhere from as little as $.10 for cash equities in the US, to up to $3,000 for custom derivatives, according to Capco. Added to these costs are brokerage, clearing and exchange (BCE) fees, which run in the $1.5 – $2.25 billion range for major trading firms.

“Equities kind of go one way, bonds might go another way, derivatives might go another way,” said Roughan. “At its core, to get to where we need to get to, it’s frankly a lot of deep data analysis in terms of understanding those elements, getting the cost data at the product level.”

Further complicating cost to trade calculations are capital charges for products, based on whether they are exchange or bi-laterally traded. Regulatory capital influences favor higher-rated counterparties. “In terms of derivatives, there are always some tiers there that require higher capital charges,” said Roughan. “As you go into some of the riskier stuff, the capital charges start going up. You do have to take that into account in terms of entering into that trade.”

Featured image via Gajus/Dollar Photo Club

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