CMCRC argues case for effective spreads

Following comments from the industry questioning the use of effective spreads for transaction cost analysis, the Capital Markets Cooperative Research Centre's Professor Michael Aitken explained why he thinks the methodology is valid.

Professor Michael Aitken has explained why he thinks the methodology used by the Capital Markets Cooperative Research Centre (CMCRC) is valuable as transaction cost analysis (TCA).

Voices from the industry had said that using effective spreads as the way to assess transaction costs in Asia Pacific equity markets omitted other important factors. They were reacting to a study produced this week by the Capital Markets Cooperative CMCRC on the relative costs of trading in Asia-Pacific markets, showing Japan to be the cheapest place in Asia to trade illiquid securities.

“Effective spreads best measure the cost of demanding liquidity in a marketplace,” said Aitken. “We weight the usual measure by trade volume/value and so explicitly take account of whether larger trades are more costly to trade or ‘walk the order book’ if there is insufficient volume at the best quote.”

The research centre compared Hong Kong, Singapore, Japan, Australia and India, using relative effective spreads to estimate the cost of demanding liquidity.

An ‘effective’ spread indicate that the figures have been weighted (accounting for, say, a group of stocks, or by volume). That indicates what might be witnessed in the market rather than just one bid and ask point.

The CMCRC study said, “In Australia, the cost of trading the least liquid group of stocksis highest at 5,481 basis points on average, whereas in Tokyo it is only 144.43bps.”

Although mindful that the findings did specify clearly that researchers were looking at effective spreads, the industry disagreed that the metric reflects ‘the cost of trading’, as it failed to take into account other key parameters.

“Effective spreads are only one factor in determining how much it costs to trade, and often are not the most significant factor,”  said Clare Witts ‎director, Asia Pacific, at ITG, an agency broker and provider of TCA services. “Normally more important to overall cost is the amount of volume available not just at the bid and ask, but also at other price points, as well as the price volatility and overall momentum of the stock one is trying to buy or sell.  This is particularly important in illiquid stocks where finding volume is the biggest challenge.”

Industry sources also expressed the view that, given differentiated markets across the region, examining tenth decile ultra-illiquid stocks in Australia where the difference between bid and offer pricesare, according to CMCRC, nearly 55% and then comparing it to Japan, where the spread is less, has limited analytical value. Furthermore, even a more comprehensive TCA would be of limited merit insofar as illiquids were concerned.

 “When trading the most illiquid stocks – particularly in any meaningful size – the accuracy of TCA models deteriorate significantly,” said Kent Rossiter, head of trading for Asia Pacific at Allianz Global Investors.

Aitken said that the CMCRC’s product quickly compared measure of market efficiency and fairness across deciles. “In this process, larger transaction costs are readily observed for smaller less liquid securities. For example if you have a A$0.02 stock, with a spread of 1/2c, bid-ask spreads are 25%,” he said. “The key implication of the result for NYSE and Tokyo is they likely have a lot less ‘low end’ securities than do other exchanges like Australia, (CMCRC added it is in the process of confirming this). This is what the minimum capitalisation rules are supposed to prevent, but many exchanges are likely less strict on such rules or have very small capitalisation requirements in the first place.”