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Chapter 1 – Financial markets and institutions
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CHAPTER 1
▶ The price impact of a trade. Usually costs go down with larger trades, but not in the case of price impact.
When a large volume of stock (relative to the average daily volumes) is bought, for example, it can create
an imbalance in demand and supply. This can only be resolved by a price change upwards, to bring in more
supply. A market maker, for example, will only trade up to a specified quantity at quoted prices before
reserving the right to change the price. The resulting price impact is the deviation of the transaction price
from the ‘unperturbed’ price that would have prevailed had the transaction not occurred (oen defined as the
volume-weighted average of the transactions surrounding the trade). Price impact can also be caused by the
‘information’ the trade provides to the market. A large ‘buy’ may be owing to new positive information that the
trader has about a company. This signal creates further demand. Similarly, a reverse argument holds for selling
and price falls.
▶ Opportunity cost. This is the ‘cost of waiting’. For example, a buy trade may be spread over a few days to
prevent significant adverse price impact. However, over those few days the price rises anyway, so that any value
that had been identified in the stock has now been depleted. This results in the full original order now being
cancelled while partially complete. Some identified value has therefore not been ‘captured’.
Now consider the explicit costs of trading. Trading equities on the London Stock Exchange involves a number
of explicit transaction costs. A
commission is charged by brokers, which ranges between 10 and 20 basis
points for large institutional trades, to between 100 and 150 basis points for smaller trades. However, for very
large institutional clients, the commission on some trades can be zero. These commissions do not currently
attract value added tax (VAT).
Stamp duty reserve tax (SDRT), which is a simple purchase tax, is also payable
on all transactions by the purchaser and is levied at a rate of 0.5%. For CREST-settled transactions, this SDRT
is rounded up to the nearest 1p; otherwise it is rounded up to the nearest £5. Finally, a further levy of £1 on all
purchases and sales in excess of £10,000 is charged to finance the Panel on Takeovers and Mergers (the PTM
levy). Market makers are exempt from paying SDRT and the PTM levy.
Regarding direct costs, a 2010 UK study by Oxera Consultants looked at the costs brokers incur in using the
trading platforms, central counterparties (CCP) and central securities depositories (CSD) for order book trading
and post-trading in UK equities. Since the MiFID legislation, there has been a rapid growth of both trading
channels (e.g. London Stock Exchange, BATS Chi-X Europe, Turquoise) and trade clearing venues (e.g. LCH.
Clearnet, EMCF, EuroCCP). The study focused on a subset of providers and excludes custody costs. It is meant to
represent the costs of a large UK broker. The study finds that transactions via the London Stock Exchange/LCH.
Clearnet/EUI channel incur 83% of costs via trading and 17% at the post-trading level. The breakdown in pence
per transaction is:
▶ Trading platform: 23.8p.
▶ CCP (including netting, clearing and settlement): 4.2p.
▶ CSD (including settlement and stamp assessment): 0.6p.
For the BATS Chi-X/EMCF/EUI channel, 41% of costs are incurred at the trading level and 59% at post-trading,
and the comparable breakdown in pence per transaction to the London Stock Exchange route above is 3p for
the trading platform, 3.8p for the CCP fee and 0.4p for the CSD component; this gives 7.3p (rounded) in total
compared to 28.5p for the London Stock Exchange route.
Clearly, the dierences in the channels are driven largely by the dierences in costs arising at the trading
platform level. Note implicit costs are not mentioned here and may be less on the larger London Stock
Exchange market. Post-trading costs are broadly in line between the dierent channels. Note that these costs
are subject to change, especially at a time of transformation and change in the exchange environment. Also,
users with a dierent profile from this large UK broker will face dierent costs.
Purchasing gilts attracts a number of transaction charges. Commission rates vary from 0.5% to 1% of the value
of the purchase for purchases below £5,000, while purchases in excess of £1m attract no commission charge.
Gilts are normally settled on the next business day. Note that purchases on gilts are exempt from SDRT. Other
securities purchases exempt from SDRT are loan stocks, foreign securities registered outside the UK, bearer
securities and deals in traded options through ICE Futures Europe.
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