TRADING STRATEGY

Phil Mackintosh
+ 1 212 325 5263
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Market Structure
How Much is Market Structure Hurting Investors?
Market Commentary 13 March 2013

Key Points Introducing our Transaction Cost Index

 Over the past decade, markets have Over the past decade, markets have become more fragmented and
changed significantly. They are faster, more complex. In our report Where Has All the Trading Gone? we noted that
fragmented and more complex. although top-line volumes have doubled, real trading liquidity has fallen to
 We try to quantify how much this has decade lows. But is it possible to quantify the economic effects of this
affected real investor returns. market structure change? And are investors better or worse off?
 Using over 7-years of real transaction data,
Transaction costs are a good metric to assess the economic value of
we create the CS Transaction Cost Index.
market structure changes – especially given that they represent the real
This index is an apples-for-apples measure
investor losses due to frictions in their trading. Using ExPRT, our
of shortfall throughout the past 7 years.
transaction cost data, we compare over 7 years of real trade costs.
 It shows that trading costs have consistently
improved throughout the period. Apples to apples shows trading is 30% cheaper
 Based on this index, and our estimates of Using ExPRT data, we estimate that transaction costs, on a like-for-like
real investor trading, we calculate that real basis, have fallen around 30%. Our approach seeks to remove the
investors are saving around $10bn per year, effects of volatility, trade size and execution style that can, on their own,
versus equivalent 2005 trading costs. lead to material shifts in a simple average cost number, but are not
caused by micro-market structure itself. We detail how we do this below.
Exhibit 1: CS Transaction Cost Index (all US trades)

Using ExPRT for the Index

ExPRT is our proprietary TCA tool, which we use
to analyze and consult with clients on their Transaction Cost Index
transaction costs and execution strategies (see
ExPRT for Dummies).
On an overall basis it represents a broad range of Source: Credit Suisse Trading Strategy

Institutional investors by style and size, trading via The CS Composite Cost Index (exhibit 1, red line) represents the
Cash, PT and Algorithmically. indexed value of actual trade costs. This line is shaded according to the
We have also used ExPRT to calibrate our impact VIX at the time. From this it is clear that costs spike during periods of
cost model (see: A New EDGE in Impact Cost higher volatility. Despite volatility being around 50% (5 points) above
and EDGE Update: **NEW Portfolio Tools**). record lows, this index recently hit record lows.
Just shortfall The CS Transaction Cost Index (black line) goes one step further,
ExPRT just looks at shortfall on trades. Arguably neutralizing the impact of volatility spikes, creating a better ‘apples to
settlement and commission costs have also apples’ comparison of execution costs. This shows transaction costs
declined. However they are not included in these have actually fallen consistently over the period, and it is now around
results. 30% cheaper to trade than 7 years ago.
(212
(
 TRADING STRATEGY

Building Better Cost Indexes:

Accounting for a decade of significant change
We know from A New EDGE in Impact Cost how changes in trade size
and volatility significantly affect costs, however they have little to do with
market structure. Not surprisingly, these are also key components in our
Exhibit 2: Our Impact cost model shows trade pre-trade impact model:
size and volatility also affect costs

Accounting for changes in transaction size

Exhibit 3: Indexes of different trade sizes were As desks become more and more electronic, we know that average trade
consistent. Averaging these averages avoids size has fallen significantly, and quant funds with diversified portfolio
structural shifts in trade size affecting the index. trades have increased. Cheaper explicit transaction costs have also
Average shortfall over time by trade size allowed smaller trades and higher turnover strategies to become more
(all flow types, market orders only) economic. Consequently a simple average of trade cost might be
Transaction Cost Index (for each size bucket)

6
distorted by changes in the size & composition of orders received.
0 - 1% of ADV
5 1 - 2.5% of ADV We account for size in our index by:
2.5 - 5% of ADV
5 - 10% of ADV
4
10+% of ADV
1. Bucketing orders by size, measured as % of ADV. This ensures that
large and small orders are segregated. We highlight that these
3 results are also conservative, as increased volumes mean there are
typically more shares in a 1% ADV order now than 7 years ago.
2
2. Indexing each bucket so that the cost of trading each bucket is set
1 to 1 at the start of the period. Interestingly exhibit 3 shows that,
despite differences in notional shortfall between the smallest and
0 largest buckets, each index is mostly consistent. Very large orders
Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 may have improved marginally more than other orders in the past 2
Source: Credit Suisse Trading Strategy. years.
Exhibit 4: Our model’s volatility factor was a good 3. We then create our Composite Cost Index (exhibit 1, red line)
predictor for the effects of volatility changing from the average of each bucket. This means that shifts in the size
80
of each bucket, as trading patterns evolve, don’t affect the index like
70 Data a simple average of all orders would.
Model
60 Accounting for an 8x increase in volatility
50 The red shading of the Composite Cost Index shows that, just as
Impact (bps)

uncertainty makes options cost more, it also makes trading cost more, all
40
other things equal. This makes it tough to compare actual costs during
30 the past seven years, where the VIX has ranged from 10 to 80+. .
20 However, we know from Impact Model Stands Up to the Credit Crisis
10 that the volatility factor in our cost model was able to accurately forecast
the increase in transaction costs, even during the extreme volatility
0
changes of the credit crisis (exhibit 4). Consequently, it seems
reasonable to use this factor to now normalize our composite cost index
Source: Credit Suisse Trading Strategy, for the impact of VIX changes.
Impact Model Stands Up to the Credit Crisis.
Doing this, we create the CS Transaction Cost Index (exhibit 1, black
line). This represents what the Composite Cost Index should have done
had volatility, measured by the VIX, remained at a constant 20 level.

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 TRADING STRATEGY

Is Increased Market Complexity Hurting?

Exhibit 5: over the same period, fragmentation Coincidentally or not, our Transaction Cost Index has ground lower at the
and order types have increased, and primary very same time as fragmentation and complexity have ground higher.
trading has decreased.
It’s tough to know what specific changes in the market have helped the
most – or even if some have hurt – because so much has changed. We
have had regNMS, sophisticated buy-side EMS’s, growth in HFT,
competition for exchanges from ATS’s and improvement in computer
power generally.
All changes have ripple effects
The market is also a complex web of corporates, retail, broker dealers,
market makers, hedge funds, liquidity providers, quants, fundamental
investors and even index funds. Structural changes affect them in
different ways - often indirectly. For example:
 Computerization gave investors direct and cheaper access to the
markets, but also left an electronic footprint in the market.
 Technology enabled more sophisticated market making, which
tightened spreads but also increased latency.
Source: Credit Suisse Trading Strategy
 Both of these aided signal detection strategies. Which dark pools and
smaller trade sizes evolved to counter.
 Smaller trade sizes increased trade data. This grew exchange
revenue as well as routing costs. Pushing liquidity into ATS’s.
Exhibit 6: Electronic trading has grown As the market evolved, has it gotten better or worse?
throughout the period of our index.
If the primary role of the market is the efficient transfer of capital in the
economy – the ‘cost’ of trading, for real investors, is a potentially
important measure of progress (or lack there-of).
$10bn cheaper to trade
The US market trades around $200bn/day, which equates to $50tr a
year. According to Where Has All the Trading Gone?, around one-third
of this is real-investor trading. As all trades are 2-sided, this would
equate to $33tr in buying + selling per year.
A conservative estimate shows that the 30% improvement in our
Transaction Cost Index, at current levels of trading, would translate to
savings for real investors of over $10bn per year.
On balance, the changes to the market over the past decade seem to
have made trading cheaper for all investors.
Sources: Tabb Group; Rosenblatt Securities, NY Times

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 TRADING STRATEGY

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