One of the five cost categories that must be reported under MiFID II’s Cost and Charges Directive is transaction costs. The regulation breaks down transaction costs into two components:
The arrival price methodology defines the implicit cost as the difference between the mid-market cost of an asset at the time the order is placed (the arrival price), versus the price at the time of execution.
For some instruments which are standardised and traded regularly, it is likely the arrival price can be sourced from historical market data – so this is the first thing you should try. However, challenges arise when arrival prices are either difficult to source or simply not available.
Estimating Implicit Costs in the Absence of Arrival Prices
MIFID II’s costs and charges points to PRIIPs, MIFID II’s retail counterpart, for the implicit cost calculation methodology in the absence of arrival prices. The rules begin by providing guidance on suitable estimates for different security characteristics. For example, using start-of-day or previous close prices for linear instruments is permissible, as is using a fair price mid-estimate for non-linear instruments.
However, there is still a requirement to apply an element of judgement when determining whether these approximations are viable.
For example, for instruments trading intraday using mid-estimates far from the exact time of trade will likely lead to misleading results. In these cases, the methodology moves away from trying to estimate an arrival price, and instead provides a framework to estimate a bid-offer spread directly. Such approaches vary by asset class, but can broadly be split into two categories:
CASH PRODUCTS: Such as bonds, equities, and money markets.
DERIVATIVES: Such as IRS, CDS, equity swaps, ETD, OTC options, repos, and foreign exchange forwards.
How to estimate implicit costs for Cash Products
The regulation specifies the following:
INDEX: Find a suitable reference index to determine the spread of each product.
SPREADS: Use the market-weighted average spread from each constituent of the reference index, using the end-of- day quote from the tenth business day of each month for the last year.
EXAMPLES: Examples are provided in the Q&As, although the regulation does not force the use of specific reference indices (PRIIPS – Q&A, July 2017)
How to estimate implicit costs for Derivatives
For derivatives, the guidelines are much broader, and the true challenges lie as you read further into the Q&A discussions. You can read more about these challenges here.