December 15, 2010
To whom it may concern,
I am writing this letter with regard to your request for comment on Concept Release on Equity Market Structure No. 34-61358. The issue I am going to address here is focused on published analyses on institutional investor transaction costs.
Regarding the question whether published analyses generally accurately reflect the transaction costs experienced by institutional investors, my response is a no. Because it is difficult to access institutional order data that is not publicly available, we are unable to obtain voices from sufficiently diversified groups to make well-sounded discovery on institutional investors true cost. Take a look at the people who did those existing analysis. Investment Technology Group (probably most famous for POSIT system) has a huge hedge fund and asset management clientele base, and Elkins McSherry actually owns his own company under State Street that provide large institutional investors consulting services on how to control transaction costs. On one hand, there could be a potentially huge conflict of interests for them to conduct an analysis on their clients transaction costs. They probably did not want to offend their clients or potential clients. On the other hand, their relationships with large institutional investors could be the reason why they had access to those strictly guarded trading data at the first place. Large institutional investors chose to expose their transaction costs data to ITG and Elkins McSherry probably because they trusted these two that they would not expose information that would put these large investors in inferior positions or they believe it would be easy to manipulate McSherrys and ITGs analyses if they ever wanted to. Therefore, the existing analyses on institutional investors transaction costs are very much likely biased and incomplete. They could just be the pseudo-information that the institutional investors want the markets to see.
However, whether the lack of accuracy in existing analyses should lead to the Commissions more time and effort on exploring other means to assess institutional investors transaction costs remains debatable. There is a seemingly causal effect between the two. We lack accuracy here, so we need to fill in the gap now. Pose a second and think about why institutional investors do not wish to reveal their true transaction costs. First of all, a lot of the institutional investors, such as mutual funds and close-end funds, are keen on utilizing soft dollar features to hide their true transaction (research) costs. It benefits them in a sense that they get to expense less and present clients with a higher return on the paper. It hurts the investors because they cannot tell whether a funds performance is truly good or bad. Secondly, exposure of institutional investors transaction costs information could well put them in a more competitive setting. If one investor has been successful in reducing certain type of costs while competitors in the industry has not been, opponents may start to find out the reason behind it and this investor may very likely lose that competitive advantage soon. Therefore, transaction costs are like trading secrets in a sense that it was one of the factors that differentiate institutional investors of similar type. The Commission should not interfere with that.
One thing the Commission could do is to initiate an annual transaction costs audit process where an impartial third party will go through institutional investors procedures regarding calculation transaction costs, recording transaction costs, and reducing transactions. Certain predetermined practices on transaction costs avoidance or misusing or falsifying would be publicized to the general public. This will pose a significant penalty to the institutional investors because reputation means more than anything in this industry. Tainted reputation would directly impact their trading efficiencies, price improvement, liquidity demand, and revenue streams. Hopefully this audit could help institutional investors clients make better-informed decisions when choosing who they want to deal their business with.