Proposed Amendments to Transaction Cost Calculations under PRIIPs
The European Supervisory Authorities (ESAs) recently issued a consultation paper that includes two draft proposals for changes to transaction cost calculation requirements outlined in Annex VI points 7-23, among other proposed amendments to the PRIIPs KID. The first proposal seeks to reduce the impact of negative implicit costs on net transaction cost disclosures, in addition to providing guidance for transactions executed on an OTC basis, costs associated with non-financial assets, and costs associated with low turnover asset classes. The second proposal also seeks to reduce the impact of negative implicit costs but includes a provision to replace the arrival price methodology with a more principles-based approach to select a suitable benchmark.
The primary concern raised by market participants is that negative implicit costs, or orders where the average execution price experiences a net improvement versus the prevailing arrival price (see Figure 1), are not well understood by retail investors. The ESAs intend to resolve this problem by requiring PRIIPs manufacturers to disclose a minimum of explicit transaction costs where aggregate implicit transaction costs are negative. This amendment is consistent in both draft proposals submitted in the consultation paper. This in effect prohibits the disclosure of zero or negative transaction costs in the PRIIPs KID, which the ESA believes this to be “confusing or at least not intuitive.”
Figure 1 Example of negative transaction costs. (Image Source: Bloomberg Markets)
The arrival price methodology captures the difference between the net realized execution price and the prevailing mid-point of the bid-ask spread at the arrival time. The arrival time is captured when the order is submitted to an executing broker, or in the event of direct market-access, the time the order is submitted to the venue. Market participants have also criticized arrival price benchmarking for recording market movements that are independent of the transaction as costs to the investor.
An example of this is provided below in figure 2, where a trader executes trades using a volume participation algorithm to reduce market impact and still underperforms the arrival price based on the intraday volatility of the security being traded. Under current rules, PRIIPs manufacturers are required to use the arrival price, but the second draft proposal replaces it with a principles-based approach. If adopted, implicit costs will continue to be measured by comparing the average execution price to a benchmark; however the PRIIPs manufacturer will now have the discretion to identify a suitable reference rate taking into consideration the size and urgency of the order and the liquidity and volatility of the security.
Figure 2 Positive price momentum resulting high implicit trading costs. (Image Source: Bloomberg Markets)
It is evident that the ESAs believe that implicit costs are integral to their transaction cost transparency initiative, so I wouldn’t expect an amendment to remove them altogether from cost calculations. However – I would keep an eye on responses to the consultation paper as they are made available sometime in the first half of 2020.
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