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May 10, 2006

The Big Squeeze on Costs: Have transaction costs bottomed?

By Wayne H. Wagner

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  • The Big Squeeze on Costs: Have transaction costs bottomed?

What drives the cost of transacting securities? Are the costs of execution supply-driven by cost-of-production factors, or are they demand-driven by the perceived value of transacting? Certainly in recent years, costs have plummeted. Take a look at the chart below of total U.S. transaction costs year by year for institutional investors, as measured by the Plexus Group.

During the frothy days at the peak of the Internet/bio-tech boom, expectations of high returns soared, as did transaction costs At the 2001 peak, my former firm, Plexus Group, recently acquired by ITG, measured all-in iceberg transaction costs-which includes commissions, market impact, timing and opportunity costs. The results came in at 142 basis points for U.S. large-cap stocks and 240 basis points for U.S. small-cap stocks. By 2005, large-cap costs had fallen by nearly two-thirds to 51 basis points, while small-cap costs dropped 59 percent to 98 basis points.

Three major factors, I believe, combined to produce this unprecedented, and downright startling reduction. The first is driven by demand, the second is supply-driven and the third represents a reformulation of the problem to incorporate new objectives:

* Money managers lowered the expected returns of their portfolios after the end of the market bubble, which also dampened volatility. Consequently, this had a positive effect on transaction costs, especially those relating to delay and missed opportunity costs. High-cost trading became simply unjustifiable in a world of humdrum single-digit expectations. Portfolios with concentrations of highly volatile stocks were quietly replaced by stocks with greater predictability-the old-fashioned diversified, large-cap stocks with heavy volume. These stocks are simply less costly to trade.

* Simultaneously, efficient, low-cost trading mechanisms like direct market access platforms became widely available. This occurred just as regulatory zeal forced out higher cost market structures through decimalization and changes to the order-handlng rules.

* Increased scrutiny of portfolio operations, combined with a maturing of the cost-measurement industry, forced managers to more carefully consider the costs of implementing their decisions.

The phenomenon was not limited to U.S. markets: Similar cost reductions were experienced in almost all market economies as exchanges worldwide developed new operating software and improved connectivity. These changes in market structure altered the economics of the brokerage business. The equity desk at brokerages became less profitable, resulting in massive layoffs of trade desk and market-making personnel.

Unable to execute trades in the traditional manner, buyside traders found themselves plunked into the driver's seat, able to maintain direct control of the order until its execution was complete. New block-trading venues such as Liquidnet and Pipeline sprung up to provide effective execution. Algorithms, direct access facilities, and basket trading automated trades that had previously been handled manually. Meanwhile, full-service, high-touch commissions came under increased scrutiny from regulators, transaction evaluators, and compliance officers. The result: a top-to-bottom restructuring of the trading linkages.

Much of the gain-or reduction in trading costs-has come from eliminating middlemen where intermediation proved unnecessary.

So where does the industry stand today? Has the industry wrung out all the fat, or has it just harvested the low hanging fruit? I still see areas for possible cost reduction, but I can also envision environments where trading costs could rise, or possibly even explode.