These words are attributed to the renowned management guru, Peter Drucker who revolutionized the way people thought about running businesses. Although there is some debate as to whether he actually uttered these words, this maxim has become a part of corporate philosophy for businesses as diverse as automobile manufacturers and advertising companies.
And the adage holds just as true when it comes to order routing and execution. A trading desk can’t improve performance, if they don’t measure and track execution results.
The industry first started looking into this question in the late ‘80’s when Berkowitz, Logue and Noser published The Total Cost of Transactions on the NYSE , which explained how a new metric called VWAP could help measure trading performance. Also that year, Andre Perold wrote The Implementation Shortfall: Paper vs. Reality, highlighting the divergence between paper returns generated by an investment model and the returns realized when the model is implemented through trading.
Benchmarks like VWAP and Implementation Shortfall enabled traders to measure their performance and the performance of their brokers; and new TCA tools gave them insight into how they could modify their trading strategy to improve results.
Of course, US equity markets have evolved significantly over the last 30 years. Now liquidity is spread out across 13 stock exchanges, over 30 registered alternative trading systems (ATSs) and numerous non-ATS venues. Meanwhile, decimalization has caused trading to fragment from 16 price points per dollar to 100. On top of this, high-speed trading and complex order types have made navigating these liquidity pools increasingly difficult.
Just as equity market structure has evolved, transaction cost analysis must evolve also, with venue analysis being the new frontier. In recent Greenwich Associates research we found that a majority of firms were currently incorporating or would like to incorporate metrics derived from venue analysis in their best execution review process.
In addition, regulatory initiatives such as the SEC’s Transaction Fee Pilot are sure to drive further interest in venue analysis. This will have a significant impact on order routing and liquidity provision, and venue analysis can help traders assess the impact of these changes and re-optimize their routing strategy long before the results of the study are made public.