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The Abyss Looks Into You - Human Nature Through the Lens of TCA

Traders Magazine Online News, February 27, 2019

Michael Ross

If Wall Street has a patron philosopher, it may well be Friedrich Nietzsche. After all, he has a book called “The Will to Power” and his famous aphorism “that which does not kill you makes you stronger” has been the guiding philosophy of risk managers, analyst training classes, associate all-nighters, and, to some, regulatory policy. Nietzsche is even given a cameo, of sorts, in the movie “Wall Street.”

Near the end of the film, just after Bud Fox has defeated Gordon Gekko, and just before his comeuppance in turn at the hands of the SEC, Lou Mannheim, the old timer, takes him aside and says, “Man looks into the abyss, and there’s nothing staring back at him. At that moment, man finds his character, and that is what keeps him out of the abyss.” It’s an odd moment, Bud Fox himself is bewildered by it. He nods his head, says he thinks he understands, walks into his office, and is promptly arrested.

It turns out, Mannheim is misquoting something Nietzsche said in “Beyond Good and Evil,” a work of Wall Street philosophy if ever there was one. The actual quote is “if you look long into an abyss, the abyss looks into you.” Oliver Stone, who wrote and directed Wall Street, certainly knew the actual quote and it’s likely the misquote is intentional. Intentional or not, Mannheim’s error and Nietzsche’s actual quote, when taken together, contain an important insight into the way that trading is being conducted today.

On the one hand, Nietzsche is correct: something Wall Streeters have long been looking into is now looking back into them. On the other, Mannheim is correct: what they are discovering is their character. What they are looking at, that can finally look into them, is nothing so terrifying as an abyss: it’s their transaction cost analysis reports.

The History of TCA

This is because the profusion of accessible data, and the advance of computing power and machine learning, have transformed TCA from a check the box exercise meant to satisfy the regulators to something else. TCA has reached a level where it can see beyond the basic elements of transaction costs and into the decision-making process. It can now see where human nature itself is its own worst enemy and still worse, the enemy of alpha.

The origins of this revolution are distant and humble. They lie in the Investment Advisors Act of 1940, which established a fiduciary duty for Registered Representatives. “Best execution” did not even exist as a concept prior to that. Even so, the definition of “best ex” has been left purposely vague. Both the regulatory authorities and FINRA say explicitly that “best ex” is not “best price.” They focus on process more than result:

they require firms to show that care was taken rather than that a specific outcome was achieved.

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