Disclosing implicit transaction costs under PRIIPs & MiFID II: the challenges of transparency
Sylvain Crepin - Partner - Advisory & Consulting - Deloitte
François Kim Huge - Partner - Advisory & Consulting - Deloitte
Valnea Skansi - Senior Consultant - Advisory & Consulting - Deloitte
Published on 28 January 2020
Strengthening investor protection and transparency has been a growing priority in the period following the last financial crisis, with regulators working towards designing meaningful and understandable risk, performance and cost metrics. In particular, complete cost transparency is required under PRIIPs, IDD and MiFID 2 legislations for financial instruments and services. Since the go-live, transaction costs disclosures and specifically “implicit” transaction costs, have attracted a lot of industry, media and public attention. This article aims to summarize the regulatory contexts and the various challenges.
What are transaction costs?
Compared to the simplified assumptions of a complete market with negligible transaction costs often used in economic modelling, in reality, there are costs intrinsically linked to the purchases and sales of financial instruments. We can divide these costs into:
- Fixed costs per transaction (explicit costs), such as brokerage fees or stamp duty
- Implicit costs, which represent the difference between the ask (resp. bid) price at which a market maker is willing to sell (resp. buy) a given financial instrument, and the mid-price (the mid-price is the average between the ask and bid price), used as reference point for its valuation.
Based on the market data used and the methodology employed, the compilation of transaction costs—the sum of explicit and implicit costs—results in significant variations within funds of the same strategy, as shown in Figure 1.
Market Transaction costs (*) based onthe Asset Class as at June 2019
Figure 1: Disclosed total transaction costs differ significantly from fund to fund, even within the same investment strategy - figures as at 30 June 2019 (in percent)
*Based on a peer analysis. Note that methodology of the sample data is not disclosed
Implicit transaction costs compilation methodologies
PRIIPs Level 2 measures detail two methodologies for implicit transaction costs compilation:
- The “arrival price methodology” or “full PRIIPs methodology”, which applies to funds operating for more than three years
- The “turnover methodology” or “new PRIIPs methodology”, which applies to
- PRIIPs operating for less than three years
- To UCITS or non-UCITS funds distributed as an underlying investment option of a PRIIP, where the PRIIP manufacturer only uses the key investor information document as a specific information document
The full PRIIPs methodology prescribes the comparison of the realized execution price of a transaction with its arrival price, defined as the mid-market price of the instrument when the order to buy or to sell was transmitted.
This difference is multiplied by the volume of the units transacted. When arrival price is not available, the regulation requires the use of the opening price of the day of the transaction, and if that is not available, the use of the closing price of the previous trading day, as arrival price, in a so-called “waterfall approach”.
The particularity of the arrival price methodology – and one of the main reasons why it is criticized – is that it takes into account, not just the actual ask/bid price of the security being purchased/sold, but also the market movement between the time the transaction was instructed and the time it was actually executed, as illustrated on Figure 2.
Figure 2: Illustrative example of the arrival price methodology for an equity trade, factoring in market movements - one of the most challenged aspects of the required method.
By contrast, the new PRIIPs methodology makes an estimation of average implicit costs incurred in a transaction based on the asset type, over a three-year window. Each transaction is assigned to a certain instrument category.
For each category, an average half bid-ask spread is estimated, based on market data over the last 12 months, to capture the implicit costs of the transaction. This spread reflects the average estimated trading cost per investment category and therefore excludes the idiosyncratic risk of individual securities.
Figure 3: Illustrative example of the new PRIIPs methodology
Due to the methodological and operational challenges we will describe in the next two sections, some market participants have also opted for a hybrid approach. It consists in applying arrival price methodology when data is readily available—mostly for listed products such as bonds, equities and FX futures, and new PRIIPs methodology with varying degrees of granularity for over-the-counter securities or when arrival price is not available.
In the MiFID 2 context, no particular methodology is imposed for calculating transaction costs, but ESMA Q&As recommend aligning the methodology with the PRIIPs one.
While PRIIPs requires ex-ante costs disclosure (the PRIIPs KID is a pre-sale document only), MiFID 2 has implemented two levels of costs disclosure: ex-ante— aimed at informing potential investors of the costs they might incur if they invest, and ex-post—aimed at informing current investors of the costs they have actually incurred during the last year.
Fund industry representatives have raised strong concerns regarding the full PRIIPs methodology, related to the accuracy and meaningfulness of the results provided.
Firstly, negative or zero transaction costs are frequently highlighted as a severe shortfall of the arrival price method. This can occur due to market movement if the difference between the initiation price and the execution price is so favourable to the investor that it offsets other transaction costs.
By contrast, market movements do not affect implicit costs obtained using the new PRIIPs methodology. More specifically, using arrival price transaction costs will always be negative for some types of transactions. Figure 4 illustrates the example of a buy limit order which will always result, if executed, in a negative implicit transaction cost.
Figure 4: Illustrative exampleresulting in negative implicit transaction costs for a buy limit order
Second, the two different methodologies prescribed by the PRIIPs regulation may result in significantly different transaction costs within a same investment category, which reduces funds comparability. Some real-life examples show up to five-percentage point difference between transaction costs of the same fund estimated with the two methodologies.*
This comparability issue is also exacerbated by the present divergence of the regulatory frameworks. For instance, the UK regulator encourages the use of the arrival price methodology for all costs disclosures efforts, including in the context of the UK Workplace Pension Policy Statement (e.g. DCPT), the Cost Transparency Initiative and MiFID 2.
Should there be a revision of the PRIIPs transaction costs methodology, this may result in the same investment fund displaying different transaction costs across various regulatory contexts and disclosures.
*EFAMA's evidence on the PRIIPs KID's shortcomings, 23 March 2018
Ensuring data quality surely represents one of the most significant operational challenges. The number of transactions to process in a three-year observation window can largely exceed 10 million for large asset managers. The data quality may involve identification and removal of duplicate, cancelled or non-market transactions, identification and specific processing of trade at market auction close, trade at issuance, and derivative transactions, among other operational elements.
Many market players agree that market data availability presents a challenge for the relevance of the results of the full PRIIPs methodology. The PRIIPs RTS explicitly state that intra-day prices may be considered as unavailable for the period prior to the start of 2018. In cases where intra-day prices are unavailable, it is permissible to use the opening or closing prices, which may distort the figures disclosed by showing market movement— the difference between transaction price and the previous closing price, for instance, as transaction costs for the investors.
For the purpose of the new PRIIPs methodology, the Association Française de la Gestion Financière (AFG) regularly publishes a half bid-ask spread matrix, estimated based on contributions from large French asset managers. While the use of this matrix ensures greater comparability of implicit transaction costs, it also represents a mapping problem in connection to reducing an investment universe on only seventeen categories. In response to this challenge, some market participants have added more granularity to this standard matrix, tailored to their investment strategy.
Similar to other types of regulatory reporting, two of the key challenges that remain are (i) ensuring governance around the computation and disclosure of transaction costs and (ii) consistency with other frameworks already in place. For instance, as disclosed transaction costs may be reduced by the amount of anti-dilution proceeds—such as proceeds from the application of swing pricing, asset managers should ensure the consistency and appropriateness of their swing pricing methodology with the transaction costs methodology. Furthermore, integration of anti-dilution proceeds may also result in negative transaction costs – which may not be the intended disclosure to investors.
The majority of market participants are challenging the prescribed transaction costs compilation methodology. The European Supervisory Authorities (ESAs) have carefully assessed the evidence regarding whether the transaction costs methodology is working as intended and have concluded that some amendments to the current rules are appropriate, as proposed in their Joint Consultation Paper of 16 October 2019. As a result, we may see amendments to the transaction costs computation and disclosure requirements in the near future. This may include a requirement to exclude implicit transaction costs when negative, to allow for an extended use of internal sources for arrival price and a simplified approach for over-the-counter securities and for PRIIPs with a low number of transactions. However, it is likely that arrival price will still be required for listed securities. Therefore, UCITS asset managers currently using only the new PRIIPs methodology will need to start to upgrade their operations to enable the arrival price data collection - or source it externally, in order to be ready by end of 2021, when the PRIIPs exemption for UCITS ends.
Transaction costs: our solutions for PRIIPs and MiFID reporting
Deloitte can provide assistance in the various steps of transaction costs compilation with a flexible approach that fits with your data, process and regulatory requirements.