Measuring transaction costs is no longer confined to bean counting. In interviews conducted over the last six months with more than 100 buy-side traders, TABB Group has found that the use of transaction cost research (TCR) is becoming a stronger factor in buy-side routing decisions and is poised to become an integral part of diverse areas such as relationship management and organizational efficiencies.
At first, TCR - which also is known as transaction cost analysis (TCA) - was about tracking and comparing commissions among similar investment management firms. Third parties, the original TCR providers, collected data from the investment managers and generated reports ranking them on transaction costs. Armed with the data, plan sponsors asked the investment mangers to justify those results. However, the definition of transaction costs quickly became more complex. During the 1990s, market structure became decentralized and liquidity fragmented among execution venues. U.S. equities began trading in pennies. Large blocks became harder to execute. The SEC released the concept of "best execution" and, voila, the buy-side needed to track the quality of broker executions.
Since last year, TABB Group has seen a 12 percent jump in TCR adoption and estimates that TCR adoption will reach 90 percent by 2007 (see Exhibit 1, below). The main use of TCR is to appease various regulatory requirements. However, monitoring commissions and broker performance now is being applied and extended in ways that may revolutionize the relationship between the buy side and sell side.
The future of measuring broker performance will be an accounting methodology that will measure the value proposition of each broker. The ledger includes research, access to company management and industry conferences, trading technology (including TCR) and soft dollar arrangements. A position within the portfolio will be annotated with the value that the broker provided. The TCR provider will then take the commissions and other transaction costs and calculate the value the broker added (or subtracted). If a broker is not providing enough actionable research ideas but has excellent execution skills, then the relationship can be modified to best utilize the strengths of the broker while avoiding the weak areas. As TCR delivers more-objective information about the exchange of goods and services between the buy side and sell side, it will move beyond tracking dollars and cents to managing relationships.