at 50, before anaggressive buyer placed a limit buy order at 48. The limit order buyer improves the marketsubstantially for market order sellers, but provides no benefit to market order buyers. Sellerswho can recognize this situation should take liquidity.The new bid also affects the decisions buyers make to offer or take liquidity. Since the new biddecreases the probability that limit orders placed below 48 will ultimately execute, limit orderstrategies that would otherwise place buy orders below 48 are less attractive. The new bid makesmarket orders more attractive to buyers, though not nearly as much as the abnormally narrowspread would suggest.
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The rule is correct when traders know nothing about values. In our example, sellers benefitgreatly if they use market orders rather than limit orders, and buyers may be slightly better offwith market orders than limit orders. The narrow spread makes market orders more attractivethan limit orders—on average—to uninformed traders.The prices at which traders place their limit orders depend on how they value the tradeoffbetween execution price and execution probability. Aggressively priced orders will more likelyexecute than will less aggressively priced orders, but the execution prices will be inferior.Traders who are more concerned about price than about trading will more likely use limit orders.Traders who are more concerned about trading than price will more likely use market orders.The decision to use market orders versus limit orders also depends on what will happen whenlimit orders do not execute. Traders who must fill their orders will trade at inferior prices whenthe market moves away from their limit orders. They can reduce their exposure to this risk byusing market orders or by placing their limit orders close to the market to increase the probabilitythat they will execute quickly. Traders who are not committed to trading only trade if they canobtain a good price. These traders—primarily traders who employ dealing strategies—often uselimit orders or firm quotes to profit from the bid/ask spread. When their limit orders do notexecute, they simply cancel them or replace them with orders placed at new prices.To derive optimal trading strategies, traders must know how execution probabilities depend onlimit order prices. The relation between these variables depends on market conditions. The mostimportant factors include total limit order size at better prices, price volatility, and trader interestin the instrument.Traders can acquire information about the relation between execution probabilities and limitorder prices using formal econometric models. Numerous vendors sell access to optimized ordergenerators that suggest order strategies based on current market conditions.Traders also acquire information about the relation between execution probabilities and limitorder prices through experience. Experienced traders who pay close attention to the market get afeel for what may happen. Buy side traders who give their brokers market-not-held orders givethem timing discretion over their orders. They expect that their brokers will use their experienceand knowledge of current market conditions to determine the best strategies for filling theirorders and to continuously revaluate those strategies as conditions change.18.2 The Order Exposure DecisionTraders expose their intentions many different ways. On one extreme, traders can publicize theirtrading interests by submitting limit orders to systems that widely display their orders. They thenhope that other traders will trade with them. On the other extreme, traders can hide theirinterests until an exchange or a broker presents an acceptable opportunity to trade. Traders mayalso trade only through brokers and exchanges that settle their trades on an anonymous basis sothat neither side knows with whom they traded. A multitude of order exposure strategies liesbetween these two extremes.
Traders decide to expose by weighing the benefits of display against the costs of display. Thebenefits are obvious. Buyers and sellers can find each other most easily when they both showthat they want to trade. This simple observation helps explain why trading tends to consolidate
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Part VOrigins of Liquidity and VolatilityIn the next two chapters, we provide broad characterizations of liquidity and of volatility. Theseconcepts mean different things to different people. Consequently, people often are confusedwhen they discuss them. The discussions in these chapters should give you a much morecomplete understanding of the origins of liquidity and volatility, and of their many dimensions.Chapter 19 explains that liquidity is the successful outcome of a bilateral search in which buyerslook for sellers and sellers look for buyers. This characterization of liquidity explains whyliquidity has multiple attributes. The chapter concludes by showing how various types of traderscooperate and compete with each other to supply liquidity.Chapter 20 breaks total volatility into fundamental and transitory volatility components.Transitory volatility is closely related to the transaction costs that uninformed traders bear.Regulators therefore are quite interested in it. The chapter concludes with a discussion abouthow statisticians can discriminate between the two volatility components.
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Chapter 19LiquidityLiquidity is the ability to trade large size quickly at low cost when you want to trade. It is themost important characteristic of well-functioning markets.Everyone likes liquidity. Traders like liquidity because it allows them to cheaply implementtheir trading strategies. Exchanges like liquidity because it attracts traders to their markets.Regulators like liquidity because liquid markets are often less volatile than illiquid markets.Market Frictions
Economists like liquid markets—security markets, contract markets, product markets, and labormarkets—because their models work better when they do not have to consider how transactioncosts affect economic decisions. When confronted with transaction costs, people trade less often.If the costs are high enough, they do not trade at all.Transaction costs in an economic system therefore are like frictions in a mechanical system.They both slow things down and can ultimately stop all activity. Economists therefore calltransaction costs market frictions.Everyone in the markets has some affect on liquidity. Impatient traders take liquidity. Dealers,limit order traders, and some speculators offer liquidity. Brokers and exchanges organizeliquidity.Given its importance, you would expect that the term liquidity would be well defined anduniversally understood. In fact, liquidity means different things to different people. Traders andregulators talk about it all the time, but rarely are they clear about what they mean.Consequently, they often fail to communicate effectively about liquidity.The confusion is due to the many dimensions of liquidity. When people think about liquidity,they may think about trading quickly, about trading large size, or about trading at low cost.Some dimensions of liquidity are more important to some people than to others. Unfortunately,people rarely distinguish among these dimensions when discussing liquidity.In this chapter, you will see that liquidity—the ability to trade—is the object of a bilateral searchin which buyers look for sellers and sellers look for buyers. The various liquidity dimensions arerelated to each other through the mechanics of this bilateral search. Traders must understandthese relations to trade effectively.Understanding liquidity is one of the primary objectives of this book. In this chapter, we willcarefully define liquidity and its various dimensions. We then will identify the various types oftraders who supply liquidity and discuss how they compete with each other.These discussions will be especially useful to you if you are a trader who needs to know where tolook for liquidity. They also will be useful to you if you intend to offer liquidity. In which case,you must understand with whom you will compete so that you can predict when you expect to besuccessful.
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You also need to understand liquidity to measure it effectively. Many traders and regulatorsregularly measure liquidity. Traders measure liquidity to determine whether their tradingstrategies are sensible given the available liquidity. They also measure liquidity to evaluate theservice they obtain from their brokers. Brokers likewise measure liquidity to evaluate the servicethey obtain from their dealers. Regulators measure liquidity to determine which marketstructures are best. No one can answer these questions, however, without clearly understandingwhat they are measuring. As a rule, you cannot measure something that you cannot define. Theconcepts presented in this chapter provide a basis for the measurement methods presented inChapter 21 (Measuring Liquidity).19.1 The Search for LiquidityLiquidity is the object of bilateral search. In a bilateral search, buyers search for sellers, andsellers search for buyers. When a buyer finds a seller who will trade at mutually acceptableterms, the buyer has found liquidity. Likewise, when a seller finds a buyer who will trade atmutually acceptable terms, the seller has found liquidity. To understand trading, you mustunderstand the strategies traders use to conduct these bilateral searches.The Most Important Bilateral Search
For many people, finding a life partner is the most important bilateral search problem that theyencounter. For others, it is finding a job. Although this book is not about how people form liferelationships and obtain jobs, all bilateral search problems have similar structures. What youlearn about how people trade securities and contracts may help you understand how people findpartners and jobs.Bilateral searches are similar to—but more complicated than—unilateral searches. You will findbilateral search strategies easier to understand if you first understand unilateral search strategies.19.1.1 Unilateral SearchesIn a unilateral search, you actively search for a good match—a good price, for example. Themain decision that you must make is when to stop the search. The general rule is to continuesearching as long as the expected benefit from an additional inquiry is greater than the expectedcost of the inquiry. The expected benefit depends on the probability that you will find a bettermatch than you have already found. As the search proceeds, this probability declines as you findprogressively better matches. The expected benefit also depends on how much better unfoundmatches might be than the best match you have already found. As the search proceeds, thepossible improvement declines as you find progressively better matches. At some point, yourexpected benefit from an additional inquiry becomes less than the cost of the inquiry. You thenstop the search and pick the best match that you found.A Unilateral Search for a 35mm Camera
Fred wants to buy a specific camera model at a low price. His time is worth 30 dollars an hour.Fred goes onto the Internet to search for the best price among mail order photography stores thatoffer the camera. After five minutes of searching at A1ePhoto’s site, he discovers that they willsell the camera for 112 dollars. After another five minutes, he discovers that BNDPicture will©2002 Oxford University Press
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sell it for 109 dollars. He decides to search again. Six minutes later, he finds that CDBirD willsell it for 119 dollars. No bargain there.Should Fred search more? He estimates that if he finds a lower price, it would be no lower than99 dollars, i.e., no more than 10 dollars less than his current best price. He also estimates that theprobability that he will find a price that low at less than 0.25. Fred’s expected gain fromsearching again therefore is less than 2.50 dollars (10 × 0.25). Since it appears that each searchtakes at least five minutes, his expected cost of searching again is more than 2.50 dollars, giventhe 30-dollar value he places on an hour of his time. Since the expected cost is greater than theexpected gain, Fred decides to stop searching. He buys the camera from BNDPicture for 109dollars.If searching is expensive, you will often stop before you have found the best possible match.You may later discover that you could have arranged a better match had you known more aboutthe alternatives. An optimal search produces the best possible result only if you are luckyenough to find it.The Economics of Divorce
Some people divorce because they learn that they have arranged poor matches. They either learnthat their relationships did not develop as they expected, or that their opportunities to form otherrelationships were better than they expected.Other people divorce because they are not mature enough to accept that even when they searchoptimally, they generally will not arrange perfect matches. When they later see other matchesthat they believe would have been better for them, they forget that they stopped searchingbecause it was too costly. They also forget that the search for a spouse is a bilateral search. Inparticular, they forget that they cannot arrange every match that they might want to arrange.In either event, people who initiate divorces presumably believe that the benefits from searchingagain, or from being single, are greater than the substantial emotional, social, and financial costsof breaking their matches. Unfortunately, many subsequently learn that their expectations werepoorly founded.If you knew ahead of time where to find the best possible match, you would of course go therefirst. In which case, the costs of searching would be very low because you already know theoutcome. In general, you will get a better outcome when your costs of searching are low.Exchanges Are Search Engines
A search engine is a system that collects information in which people may be interested. Itallows people to search through that information at a low cost.In the previous example, had Fred been able to use a search engine to locate the best price for hiscamera, he might have discovered that GR8 Film and Photo is offering the camera for 87 dollars.Search engines make markets more competitive by lowering the costs of searching.Exchanges and electronic quotation services collect information about who wants to trade. Theythen organize it so that traders can easily find the best trading opportunities. They are search
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Chapter 20VolatilityVolatility is the tendency for prices to unexpectedly change. Prices change in response to newinformation about values and in response to the demands of impatient traders for liquidity.Volatility itself changes through time. Sometimes prices are very volatile. Other times, pricesare very stable and hardly change at all. Large price changes sometimes occur in short timeintervals. Regulators and traders refer to episodes of such price changes as episodic volatility.Episodic volatility concerns many people because it can be quite scary.Volatility, risk, and profit are closely related. Every drop in prices creates losses for traders whohave long positions and profits for traders with short positions. Likewise, every price rise causeslosses for traders with short positions and profits for traders with long positions. Traderstherefore are very interested in volatility because it can have a significant impact on their wealth.If risk scares you or profits interest you, you need to know about volatility.Volatility especially concerns options traders. Option contract values depend critically on thevolatility of the underlying instrument. Options traders must be able to measure and predictvolatilities to trade profitably. Both skills require that they understand well the origins ofvolatility.Technical traders who try to interpret trading volumes also pay close attention to volatilitybecause volumes and volatility are often correlated. The relation between the two variables isnot simple, however. It depends on the origins of the volatility.Volatility greatly concerns regulators. Excessive volatility may indicate that markets are notfunctioning well. Since accurate prices are extremely important in the economy, regulators payclose attention to the markets when prices are highly volatile. They are especially attentive whenmarkets crash.In this chapter, we identify the origins of volatility and distinguish between its two types.Fundamental volatility is due to unanticipated changes in instrument values while transitoryvolatility is due to trading activity by uninformed traders.The distinction is important both for traders and for regulators. Traders must distinguishbetween the two volatility types to accurately predict future volatility, the profitability of dealingstrategies, and transaction costs. Regulators must distinguish between them because they cannothave any lasting effect on fundamental volatility, but they often can substantially affect transitoryvolatility. Depending on the policies regulators adopt, they may decrease or increase transitoryvolatility.We start this short chapter with discussions about the origins of the two types of volatility. Wethen finish by considering how to distinguish between them. Chapter 28 (Bubbles, Crashes, andCircuit Breakers) considers what regulators can do about volatility when it appears excessive tothem.
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20.1 Fundamental VolatilitySince economies use prices to allocate resources, it is very important that prices reflectfundamental values. Values change when the fundamental factors that determine them change.Prices therefore should change when people learn that fundamental factors have unexpectedlychanged. Such price changes contribute to fundamental volatility.
When new information about changes in fundamental values is common knowledge, prices maychange without any trading. For example, suppose that an unexpected killer frost descends uponFlorida overnight. The morning news will undoubtedly report the event. The next day, orangejuice futures contracts will open at a much higher price than the last price of the previous tradingday.When only a few people know new information about changes in fundamental values, pricesgenerally will change on high trading volumes. The well-informed traders will trade on theirinformation. The pressures their trades put on prices will cause prices to change to reflect thenew fundamental values.Since informed traders generally hurt dealers, and since dealers generally do not know when theytrade with informed traders, dealers try to infer information about fundamental values from theirorder flows. The inferences that they make contribute to the adverse selection spread componentintroduced in Chapter 13 (Dealers). Price changes due to the adverse selection spreadcomponent thus contribute to fundamental volatility.20.1.1 Fundamental Volatility FactorsAny factor that determines the value of a trading instrument can cause the price of thatinstrument to change. For a commodity, the most important factors are cash market supply anddemand conditions. Other important factors are interest rates and storage costs. For a bond, themost important factors are interest rates and the credit quality of the issuer. For a stock, the mostimportant factors are quality of management, the values of the company’s resources andtechnologies, the supply and demand conditions in its product markets and in its input markets,and interest rates. For currencies, the important valuation factors include national inflation rates,macroeconomic policies, and trade and capital flows. Unexpected changes in any of thesefactors generate fundamental volatility in the instrument.20.1.2 PredictabilityExpected changes in fundamental factors generally do not change prices. Informative pricesusually fully incorporate all available information about future values. Since people base theirexpectations on existing information, fully informative prices will already incorporate expectedchanges in fundamental factors. When the expected event occurs, it is not surprising, and ittherefore should not cause prices to change. Only unexpected events cause fundamental pricevolatility. Consequently, the identifying characteristic of fundamental volatility in fullyinformative prices is unpredictable price changes. An unpredictable price process is called arandom walk. Chapter 10 (Informed Traders and Market Efficiency) provides a more completeexplanation of the properties of fully informative prices.
The one exception to this rule involves price changes that are necessary to compensateinstrument holders for their carrying costs and for bearing risk. For example, the prices of zero-
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coupon bonds creep upwards over time as they approach maturity. Since they pay no interest,investors buy them at substantial discounts to their face values. The creep in prices compensatesthem for the interest payments that they otherwise would have received had they invested in astraight bond. These creeping price changes are fully predictable and therefore do not contributeto fundamental volatility. Note, however, that if interest rates unexpectedly fall, the prices ofzero-coupon bonds will immediately rise to reflect the new interest rates. This unexpected pricechange would contribute to fundamental volatility.20.1.3 Storage CostsCommodities that are expensive to store are often quite volatile. The high storage costs ensurethat producers and distributors generally will not hold large inventories. When demand exceedssupply, buyers can quickly deplete inventories. Prices then spike up until new production canrelieve the shortage. Conversely, when inventories are large and new product will soon arrive,distributors may greatly discount the inventory to make room for the newly arrivals.
Price volatility in high storage cost commodities depends on the time it takes to adjust the flowof product from the producers to the consumers. If the production pipeline is quite long so thatadjustments take a long time, prices may be quite volatile.Price volatility in high-storage cost commodities also depends on demand variation. Whendemand is highly variable, inventory imbalances may often occur. The production anddistribution may be unable to adjust as quickly as the demand changes. For low storage costcommodities, inventories generally buffer mismatches in the rates of production andconsumption so that prices are more stable.Finally, price volatility in high-storage cost commodities also depends on whether people caneasily do without them. If the demand is highly inelastic, people will demand approximately thesame quantities at any price. Such goods often experience sharp price spikes when shortagesdevelop.Gasoline, Diesel Fuel and Heating Oil Volatility
Gasoline, diesel fuel, and heating oil are expensive to store because they require very large tanks.The available producer storage in the United States amounts to only 9 days of consumption ofgasoline and 18 days of distillate fuels (heating oil and diesel fuel). Since the demands for thesefuels are highly inelastic, unexpected fluctuations in demand caused by weather, refineryaccidents, or changes in the economy often cause substantial variation in the prices of thesecommodities.Source: Year 2000 consumption and refinery working storage capacity data obtained from the Energy InformationAdministration, US Department of Energy at www.eia.doe.gov.
Perishable goods are goods that become worthless if they are not used before they expire. Theprices of perishable goods are often especially volatile because they cannot be storedindefinitely. Where a surplus of soon-to-perish goods exists, prices fall very quickly as theirowners try to avoid a complete loss. If a shortage of perishable goods develops, prices may risevery quickly.
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Part VIEvaluation and PredictionIn the next two chapters, we consider how traders measure and predict portfolio performance.Traders need to monitor their performance so that they can determine what they are doing well,and what they are doing poorly. They then can better manage their trading. As a rule, youcannot manage what you cannot measure.How well a portfolio performs depends on the instruments that are in the portfolio and upon thecosts of constructing and maintaining the portfolio. The problem of choosing the bestinstruments to maximize portfolio performance is the portfolio selection/composition problem.The problem of implementing portfolio composition decisions is the portfolio implementationproblem. Traders must obtain good solutions to both problems to perform well.In practice, few profit-motivated traders consistently outperform the market. Most active traderslose because they trade too much and because they pay too much to trade. The costs of tradingeventually overwhelm any informational advantages that they may have. Traders therefore mustunderstand their trading costs.In Chapter 21, we focus first on measuring and predicting implementation performance. Formost traders, the portfolio implementation problem is easier to solve than theselection/composition problem. Because most traders cannot consistently outperform themarket, the implementation problem is their more important problem. In Chapter 22, weconsider why superior selection/composition performance is difficult to achieve and even moredifficult to predict.
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Chapter 21Liquidity and Transaction Cost MeasurementTraders pay attention to their transaction costs because transaction costs make implementation oftheir trading strategies expensive. Transaction costs are most important to traders who tradefrequently or who trade large sizes. For most active traders, transaction costs are the mostsignificant determinants of their total returns. Speculators who perform poorly usually do sobecause their transaction costs exceed the values of their trading strategies.Traders measure their transaction costs to evaluate how well they and their brokers haveimplemented their trading strategies. Traders must evaluate implementation to manage iteffectively. They must know whether they have been trading too aggressively—or notaggressively enough—to optimize their order submission strategies. They also must know howwell their brokers work on their behalf to decide which brokers should receive their orders in thefuture.Traders also estimate future transaction costs to predict the costs of implementing various tradingstrategies. Clever strategies may not be profitable if the costs of implementing them are toogreat. Transaction cost prediction especially concerns large traders in illiquid markets. Theirstrategies may be profitable if implemented in small size, but the price impacts of implementingthem in large size may cause them to lose on net.Transaction cost measurement also interests exchanges, brokers, regulators, and investmentsponsors for the following reasons:•
Exchanges conduct transaction cost measurement studies to document the quality of theirmarkets. They use the results in their marketing efforts. They may also use them to evaluatetheir brokers, dealers, and specialists.
•
Brokers conduct transaction cost measurement studies to document their performance. Theyuse the results to identify their shortcomings, to market their firm’s services, and to confirmthat they obtain best execution for their clients. The last purpose is especially importantwhen dealers pay brokers to route orders to them. Government regulations, exchangeregulations, and common law require that brokers ensure that payment for order flowarrangements do not hurt their clients. Brokers therefore must regularly and rigorouslyexamine execution quality to ensure the most beneficial terms for their customers' orders.
•
Investment sponsors must ensure that they obtain value for the commissions that theirinvestment managers spend on their behalf. The US Department of Labor requires thatpension funds covered by the Employee Retirement Income Security Act (ERISA) recognizethat trading commissions are fund assets that they must conserve. Fund trustees thereforeconduct transaction cost measurement studies to determine whether their funds obtainappropriate value for their commissions.
•
Regulators often try to promote policies that lower transaction costs. Regulators thereforeconduct transaction cost measurement studies to characterize the performance of variousmarket structures. The US Securities and Exchange Commission now requires that allmarket centers—exchanges, ECNs, and dealers—collect and publish highly disaggregated
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data that traders can use to evaluate average execution quality for various order types andsizes.We consider how to measure liquidity in this chapter. We will examine both retrospective andprospective measures of transaction costs. We consider first retrospective measures oftransaction costs. We then consider how traders use information about past transaction costs topredict future transaction costs.21.1 Transaction Cost ComponentsDefining and measuring exactly what we mean by the term “transaction costs” is difficult. Thisentire book is about understanding what transaction costs are, where they come from, and how tomeasure them. We explore these questions in detail throughout this book.
For our present purposes, transaction costs include all costs associated with trading. These costsinclude explicit costs, implicit costs, and missed trade opportunity costs.Explicit transaction costs are all costs that a cost accountant would easily identify. These costsinclude commissions paid to brokers, fees paid to exchanges, and taxes paid to government.Explicit transaction costs also include any resources that traders devote to the trading process.For example, the costs of setting up, staffing, and running a buy side trading desk are all explicitcosts of trading.Implicit transaction costs are the costs of trading that arise because traders generally have animpact upon prices. For example, traders who buy at asking prices and sell at bid prices pay thebid/ask spread when trading. The spread is an obvious and important cost of trading. Likewise,when large buyers push prices up and large sellers push prices down, the price impacts of theirtrading are transaction costs.Missed trade opportunity costs arise when traders fail to fill their orders or when they fail to filltheir orders in a timely manner. Suppose that a speculator wants to buy 100 cotton futurescontracts at the New York Board of Trade when the price is 65 cents per pound. In an effort toobtain a good price, the trader submits a buy limit order with a limit price of 64.95 cents. Theprice of cotton subsequently rises to 68 cents, and the order does not execute. Had the tradertraded more aggressively and filled the order at an average price of 65.25 cents, he would havemade 2.75 cents per pound, or 1,375 dollars for each 50,000-pound contract. Because the traderfailed to trade aggressively, he lost the opportunity to make 137,500 dollars. Traders need tokeep track of their opportunity costs so that they can determine whether they are tradingaggressively enough.Explicit transaction costs are the most easily measured of the three types of transaction costs.Measuring them is a simple cost accounting exercise in which the analyst identifies and sums upall commissions, fees, and explicit expenses associated with trade process.Implicit transaction costs and missed trade opportunity costs are harder to measure because theyrequire some benchmark against which to compare trade and no-trade prices. To measure theprice impact of a completed trade, analysts must estimate what prices would have been had thetrade not taken place. To measure the opportunity cost of an uncompleted trade, analysts mustestimate the average prices at which the trade would have taken place had it been completed.These estimation problems make transaction cost measurement a difficult and imprecise science.
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21.2 Implicit Transaction Cost Estimation MethodsTraders estimate implicit transaction costs using specified price benchmark methods andeconometric transaction cost estimation methods. The price benchmark methods are the mostcommonly used methods. They are easier to implement than the econometric methods andgenerally more useful when traders need to evaluate transaction costs for specific trades. Theeconometric methods are most useful for estimating average transaction costs for a wholemarket.
Most traders measure transaction costs relative to specific price benchmarks. The pricebenchmark provides a basis for determining whether buyers paid, and sellers received, good orbad prices.When traders use a specified price benchmark, they estimate the per unit transaction cost as thedifference between the trade price and the benchmark price. For a purchase, the estimated cost isthe excess of the trade price over the benchmark price. For a sale, it is the opposite. They thenmultiply this difference by the trade size to obtain the estimated transaction cost:TradePrice − BenchmarkPrice for a purchaseEstimated Cost = TradeSize ×  BenchmarkPrice − TradePrice for a sale
Estimated transaction costs thus are high when buyers pay high prices, and when sellers receivelow prices.Note that the estimated transaction costs for all buyers and sellers in a trade exactly sum to zero.Transaction cost to one side is trading profit to the other side. Traders who demand liquiditytend to pay transaction costs while those who offer liquidity have negative transaction costs.The Flip Side
Transaction costs concern everyone in the trading industry. Sell side institutions—brokers,dealers, and exchanges—try to sell low cost transaction services. Buy side institutions try toobtain transaction services at low cost. To a casual observer, it would appear that everyonewants low transaction costs.Not so. Transaction costs to the buy side are revenues to the sell side. Sell side institutionswould like their revenues to be as high as possible. They only market low cost transactionservices because they compete with each other for buy side business.These comments suggest that sell side institutions benefit from high transaction costs. While thismight be true in the short run, it has not been true in the long run. Decreases in transaction costshave caused buy side traders to greatly increase the volume of their trading. The increasedvolume, coupled with substantial decreases in the costs of providing transaction services, haveincreased sell side profits even as buy side transaction costs have fallen.For convenience, the difference between the trade price and the benchmark price is often calledthe signed difference, where the sign of the difference is understood to be one if the trade is apurchase and minus one if