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.
Certainly, NYSE CEO John Thain and Nasdaq CEO Bob Griefeld see further available efficiencies and are moving their exchanges toward capturing additional order flow through faster, lower cost trading. Regulators seem to be piling on the bandwagon as well: Reg NMS from the SEC, new rules from the U.K's Financial Services Authority, and MiFID in Europe.
Areas that could see increased efficiency include:
* The clearing process. A credit card transaction can be validated within seconds after the purchase. Options markets clear overnight, so why should it take three days to electronically clear an equity trade?
* Soft dollar practices and commission direction that force managers to use higher cost trading venues.
* Practices that force trades into operationally inefficient situations. For example, the rule that mutual fund shareholders can sell any number of shares at the closing price occasionally forces managers into panic sells no matter what the cost.
* Cross-market trading barriers that make simultaneous trading of two instruments such as equities and options more difficult.
Technological progress continues at its historical pace, and improved horsepower, connectivity and mass storage will continue to spawn new applications. So there are continuing opportunities to make equity trading more efficient. When reviewing recent data over several quarters, however, I noticed transaction costs have begun to tick up in markets other than the US. Is this the beginning of a trend? It's hard to say.
In some areas, costs have increased: Compliance strictures have greatly increased the operating costs of exchanges, brokerage firms, registered investment advisers and even issuing companies. Someone has to pay these compliance costs, and ultimately, those costs will be extracted from the pockets of investors.
All the disintermediation has put intense profitability pressure on the equity desks of all brokerage firms. Pressure on the commission and decimalization's squeeze on spreads have punished profit margins. As the less efficient firms are closed down or merged, more efficient firms will regain pricing power.
The costs of maintaining and operating a transaction-production industry ultimately define the lower bound of what it will cost investors to execute a transaction. Lower costs of transacting make more investing ideas actionable, thus increasing the volumes and spreading the fixed costs over much higher trading volumes.
But, as the internet boom has taught us, the upper bound of what a manager is willing to pay for a transaction is determined by the anticipated benefit of executing the transaction. If owning a hot stock is projected to yield a 20 percent gain, the portfolio will still benefit even if the manager has to pay up into the high teens to execute that trade. So if, or better said "when," we enter another period of high growth and exuberant expectations, transaction costs will again rise. We may be seeing a bit of that now.
In the meantime, new technologies, competitive pressures, and the desire to enhance returns by all means possible will continue to improve the cost efficiencies and quality of trading. Think Toyota or Wal-Mart: how the zeal to produce the highest possible quality at the lowest possible costs has led to decades of increasing effectiveness.
This is going to sound like an economist's "on the other hand" statement, but my conclusion is that transaction costs will continue to decline. Unless-you guessed it-they don't.
Wayne H. Wagner is the founder of Plexus Group, a pioneer in trade-cost measurement now owned by ITG. He recently formed OM/NI Consulting Partnership.
