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November 8, 2005

Academic Cautions on VWAP

By Gregory Bresiger

Larry Harris, formerly chief economist at the Securities and Exchange Commission, is reviewing the practice of guaranteed VWAP. Harris, a University of Southern California professor, is authoring a paper on the issue. He cautions that just because certain trading practices are accepted, that doesn't mean they are right.

"The defense that many people do it," Harris told Traders Magazine, "could put a firm in real danger from a compliance or legal point of view."

Larry Harris, formerly chief economist at the Securities and Exchange Commission, is reviewing the practice of guaranteed VWAP. Harris, a University of Southern California professor, is authoring a paper on the issue. He cautions that just because certain trading practices are accepted, that doesn't mean they are right.

"The defense that many people do it," Harris told Traders Magazine, "could put a firm in real danger from a compliance or legal point of view."

Using a VWAP benchmark, investors are expected to obtain at least that average price for their trades. VWAP is often a factor in measuring buyside traders compensation. But with a guaranteed VWAP trade, the broker is promising to execute at a certain price. That means the broker may have an incentive to move the market to ensure that the average is raised and an advantageous price is obtained. The broker is taking a risk that he will achieve at least the VWAP, a risk that the client might not fully understand, Harris said.

"Guaranteed VWAP usually serves the needs of investment managers and brokers rather than plan sponsors," Harris added. He noted the U.S. Department of Labor which oversees defined benefit plans could suddenly become very interested in guaranteed VWAP practices along with the SEC.

Harris says the VWAP and other benchmarks were recognized by the SEC as part of Reg NMS. However, after further study, guaranteed VWAP arrangements which he says are essentially unregulated cash-settled forward contracts will likely be closely examined by the regulators, Harris predicted.

"Such contracts present some regulatory problems that the SEC has not yet adequately addressed. In particular, these contracts give incentives to dealers to engage in non-strategic trading that benefit them rather than the clients," Harris said.

"Specifically, dealers have an incentive to trade aggressively when offering guaranteed VWAP prices and to trade late when offering guaranteed VWAP prices and to trade aggressively late when offering guaranteed closing prices," he added.

Nevertheless, Harris says that guaranteed VWAP is used because it is a custom among many firms. He says it may seem right because it appears to be what clients want. "But one has to imagine that if one were the only trader in a market, then one wouldn't use it."

He added that VWAP falls short as a benchmark, unless it is used in a strategy with an agency broker. Still, Harris says that implementation shortfall is a better way to measure transaction costs.