Inside the Black Box: The Simple Truth About Quantitative Trading

5.1. DEFINING TRANSACTION COSTS

It is useful to understand what the costs of trading actually are, since we are describing ways to model them. Transaction costs have three major components: commissions and fees, slippage, and market impact.

5.1.1. Commissions and Fees

Commissions and fees, the first kind of transaction costs, are paid to brokerages, exchanges and regulators for the services they provide, namely access to other market participants, improved security of transacting, and operational infrastructure. For many quants, brokerage commission costs are rather small on a per-trade basis. Quant traders typically do not utilize many of the services and personnel of the bank but instead use only the bank's infrastructure to go directly to the market. The incremental cost of a trade to a bank is therefore very small, and even very low commissions can be profitable. Given the volume of trading that quants do, they can be extremely profitable clients for the brokerages, despite the diminutive commissions they pay. Some quants utilize significantly less of the bank's infrastructure and therefore pay even lower commission rates than others who use more and pay higher rates.

Commissions are not the only costs charged by brokerages and exchanges. Brokers charge fees (which are usually a component of the commissions) for services known as clearing and settlement. Clearing involves regulatory reporting and monitoring, tax handling, and handling failure, all of which are activities ...