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September 22, 2005

Rethinking Pre-Trade: Brokers re-write the rules of pre-trade cost analysis

By Peter Chapman

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  • Rethinking Pre-Trade: Brokers re-write the rules of pre-trade cost analysis
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A new view of pre-trade strategies

Trade cost prediction doesn't get much respect, but that isn't stopping the Street's equity shops from rolling out new models. This summer, three of the largest institutional brokers launched efforts to bring the nascent science of pre-trade transaction cost analysis to their buyside customers. Credit Suisse First Boston, Piper Jaffray and Lehman Brothers are all debuting new systems and/or integrating their technology with buyside order management systems.

None of the three claims to have come up with a methodology that forecasts a trade's cost with 100 percent accuracy, but all say they have improved upon the status quo.

"The general impression in the industry is that the practice of estimating transaction costs is not very worthwhile," says Piper exec David Mortimer, "so we do it differently."

Execs at CSFB echo Mortimer's comments. "Most of the models I've seen are not based on any scientific research," comments Merrell Hora, a quant in CSFB's advanced execution services group. "They are just assumptions that are convenient for computation. It's garbage in; garbage out. That approach gives you the results we hear about."

Those results are believed by the experts to be in the 11 percent to 12 percent range. That means that a pre-trade cost estimate is accurate no more than 12 percent of the time.

"Figuring out transaction cost with [market] movement is the equivalent of figuring out price," notes trade cost maven Wayne Wagner of Plexus Group. "And if you can figure out price, there are more lucrative ways of putting that idea to work." In other words, if one can accurately forecast the expected cost of a trade, he or she could earn more trading for a hedge fund than servicing clients.

The level of accuracy generally improves when estimating cost for an entire basket of trades, most sources agree. That's because the law of averages is likely to bail out an intrepid forecaster. Among a basket of 200 names, 100 names may trade at prices worse than expected, but the other 100 might do better. The overall cost may not vary excessively from the forecast.

Estimating costs for baskets is not new. The practice developed on the blind-bid desk of Salomon Brothers with the creation of its StockFacts Pro cost and risk forecasting product. Estimating costs for single stocks however is now the focus of much industry research. The effort coincides with the growth in algorithmic trading. Brokers are pitching pre-trade for single stocks to the buyside as a way to help them pick the appropriate algorithm.

Both Piper and CSFB are launching new products. Lehman came out with a single-stock pre-trade offering earlier this year, and recently announced its availability in the Bloomberg terminal. Most of the larger houses now include pre-trade cost analysis among their services for money managers.

Below are some highlights of the brokers' efforts.

Credit Suisse First Boston