Top Five Worst Practices for Foreign Exchange TCA

By Jon Fatica, Global Head of Analytics, TradingScreenjonfatica.jpg

Buy side interest in Transaction Cost Analysis (TCA) has reached new highs after potential rigging of FX fixings was uncovered.

As the buy side ponders whether they have “left money on the table,” many  firms have realized that  Transaction Cost Analysis is a “must have,” rather than “nice to have.”

Many potential buyers of TCA are working off compliance checklists of best practices to adopt. Unfortunately, these lists are far from foolproof; adopting these best practices won’t ensure lower transaction costs, improved transparency into the full investment process, or improved execution quality.

Rather than produce yet another best-practice list, I thought it might be more helpful to create a list of WORST-practices – things to definitely avoid – to educate buyers on how to stay away from expensive TCA mistakes:

  1. Approaching Foreign Exchange Execution As An Afterthought: At many firms, foreign exchange settlement is a trading afterthought in the sense that it is just an operational process and not a risk-taking activity. This creates an ironic situation where traders sweat and fret over local currency price improvement, only to give it all away, needlessly, when the foreign exchange portion of the transaction is settled.
  2. Putting All Your Faith In Three-Quotes Rule: Obtaining three competing quotes on each transaction sounds like a good strategy to ensure that you are receiving competitive pricing. However, it ignores other more sophisticated execution tactics and the timing of the transaction. For example, obtaining three competing quotes near the volatile fixing time of day can produce pricing that is much worse than other highly-liquid times of the day. There are many tactics involving timing, size of order (spread rises geometrically by size of order), use of algorithms, partial/optimal netting, and many other criteria that need to be in the trader’s tactical arsenal to ensure best execution.
  3. Not Being Able To Access The Data After The Trading Is Done. Many traders cannot export their transactions from their execution platform for analysis. Obviously, this limits their ability to analyze it. Because foreign exchange lacks a centralized system of record, it’s critical for users to find a way to see the bigger picture of aggregate pricing, across dealers, and over time. Having multi-dealer, streaming data available for analysis in an integrated OMS / EMS platform is the new gold-standard for being able to produce meaningful transaction cost analysis, especially within foreign exchange.
  4. Maintaining Dealer Relationships That Are Opaque, Or A Bit Too Cozy. There is nothing wrong with a dealer taking a trader out for some surf and turf, as long as that broker is supplying superior execution as well. It’s important for buy side firms to have transparency into execution costs of all dealers, and pay special attention to relationships where transaction costs are consistently, or even “occasionally,” high. Otherwise, that steak and lobster could turn out to be the most expensive meal that a firm ever pays for.
  5. Having TCA That Is Purely Retrospective, And Detached From Trading.  The best TCA insights won’t do a firm any good if nobody is paying attention to the poor grunt producing  the reports. At many firms, the transaction cost analysis function is separated from trading, producing backwards -looking analysis that has little impact on the day-to-day operations of traders. This retrospective TCA can be important, as long as those insights are read and acted upon to shape future trades. It is even better when traders can see real-time TCA integrated into their workflow, as this can actually improve alpha, in addition to helping traders avoid some expensive mistakes.

Transaction Cost Analysis is an essential safeguard for the buy side to ensure that it receives best execution. Now, more than ever, it’s important for the buy side to have as clear an understanding of the underlying transaction costs and changing micro market structure, as they would their overall returns.

That said, great tools don’t work without great procedures behind them, and great analysis offers no insight if it’s never read.

Adopting best practices, and carefully avoiding the worst-practices, will ensure better transaction quality and lower costs for all investors.