## **Learning Outcomes**

This article explains market microstructure and transaction cost analysis (TCA) in the context of CFA Level 3 portfolio implementation. It clarifies how trading venues, order types, and liquidity conditions shape explicit and implicit transaction costs, and how these costs affect implementation efficiency and manager evaluation. It distinguishes pre-trade from post-trade TCA, showing how traders estimate, measure, and attribute costs before and after execution. It details the main cost components faced by institutional investors—commissions, fees, bid–ask spreads, market impact, delay (slippage), and missed trade opportunity cost—and links each to specific market features. It presents implementation shortfall and VWAP as core TCA benchmarks, highlighting their formulas, interpretation, strengths, and exam-relevant limitations. It demonstrates, through worked examples, how to decompose total trading cost into spread, impact, delay, and opportunity components and how those diagnostics inform order sizing, timing, and execution strategy selection. It also discusses how TCA outputs support performance review, broker and algorithm evaluation, and risk management, and to address calculation-based and conceptual exam questions on when and why different TCA tools should be applied.

## **CFA Level 3 Syllabus**

For the CFA Level 3 exam, you are expected to understand the role of market microstructure and cost measurement in portfolio implementation, with a focus on the following syllabus points:

- Describe components of transaction costs and their sources (explicit and implicit costs)
- Explain and compare pre-trade and post-trade TCA approaches
- Evaluate how market microstructure (order types, liquidity, market impact, information leakage) influences costs and trading outcomes
- Calculate and interpret key TCA benchmarks, such as implementation shortfall and VWAP (Volume Weighted Average Price)

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is the primary distinction between pre-trade and post-trade transaction cost analysis?
2. List three main components of implicit costs.
3. Which transaction cost measurement best captures missed trade opportunity cost?
4. Why might a trader choose implementation shortfall over VWAP as a performance benchmark?

## **Introduction**

Market microstructure determines how trades are executed, filled, and priced. For CFA Level 3, you need to understand not only the structure of different markets but also how trading costs arise and are measured—both before a trade occurs (pre-trade TCA) and after execution (post-trade TCA). Accurate assessment and control of trading costs is central to implementation efficiency and overall portfolio performance.

> **Key Term: market microstructure**
> The study of how market characteristics—such as order handling, liquidity, information flow, and execution systems—influence the process, timing, and cost of trading assets.

## MARKET MICROSTRUCTURE AND TRANSACTION COSTS

Trading costs are typically categorized as explicit and implicit. Both matter for implementation, manager evaluation, and TCA.

> **Key Term: explicit costs**
> Direct, easily observed expenses such as commissions, fees, taxes, and exchange charges.
>
> **Key Term: implicit costs**
> Indirect, less visible costs not reported directly—such as bid-ask spreads, market impact, delay (slippage), and missed trade opportunity costs.

### Components of Implicit Costs

- **Bid-ask spread:** The difference between the quoted selling (ask) and buying (bid) prices.
- **Market impact:** Adverse price movements caused by the trade itself.
- **Timing/delay (slippage):** Cost from waiting or slow execution.
- **Missed trade opportunity:** Cost when a desired trade cannot be completed due to insufficient liquidity or adverse price movement.

### **Worked Example 1.1**

You need to buy 20,000 shares of a small-cap stock. The quoted bid is \$10.25, ask is \$10.35, and the stock is illiquid. You submit a limit buy order at \$10.28 but complete only 5,000 shares, with the rest unfilled as the price moves up to \$10.60. What costs have you incurred?

> **Answer:**
> You have paid half the quoted spread on the completed shares (0.05) and incurred "missed opportunity cost" on the remaining 15,000 shares, as their price rose before you could complete the order. Slippage could further increase total cost if prices move during your attempted execution.

## TRANSACTION COST ANALYSIS (TCA): AN OVERVIEW

Transaction cost analysis (TCA) is the process of quantifying, evaluating, and attributing trading costs, both to improve trading strategies and support manager evaluation.

> **Key Term: transaction cost analysis (TCA)**
> The measurement and decomposition of trading costs incurred in executing investment decisions, used for performance assessment and process improvement.

TCA can be classified into **pre-trade TCA** (cost estimation before trade) and **post-trade TCA** (cost measurement and attribution after completion).

> **Key Term: pre-trade TCA**
> The estimation of expected transaction costs prior to order execution, factoring in spread, volatility, market depth, estimated market impact, and urgency.
>
> **Key Term: post-trade TCA**
> The retrospective measurement and analysis of actual trading costs incurred, benchmarking performance and identifying sources of cost.

### **Worked Example 1.2**

Before selling a \$10 million position, an institutional manager uses pre-trade TCA to estimate likely costs. The stock has a typical spread of \$0.04, moderate depth, and historical volatility of 1.5% daily. The desk estimates \$18,000 in market impact, \$2,000 in commissions, and \$4,000 in slippage. What is the value of pre-trade TCA in this setting?

> **Answer:**
> Pre-trade TCA provides a realistic expectation for total cost and helps the manager determine execution urgency, order type (e.g., algorithmic, VWAP), and whether to break the order into tranches to minimize impact. If estimated costs are too high, the manager may adjust order size or timing.

## TRANSACTION COST MEASUREMENT FRAMEWORKS

### Implementation Shortfall

Implementation shortfall (IS) is the most comprehensive metric of realized trading costs, capturing both explicit and implicit costs (including delay and missed trades).

> **Key Term: implementation shortfall**
> The difference between the portfolio return assuming instant execution at decision price and the actual realized portfolio return after execution, measuring total trading cost including missed trades and price impact.

IS is calculated as:

Implementation Shortfall = (Decision Price – Final Execution Price) × Executed Shares + (Decision Price – End Price) × Missed Shares + Explicit Costs (commissions, fees)
VWAP (Volume Weighted Average Price) is another common TCA benchmark. It compares trade prices to the market’s average traded price, but unlike IS, VWAP can be manipulated and does not capture opportunity costs as effectively.

> **Key Term: VWAP**
> The average price of a security over a given period, weighted by trading volume in each interval.

### **Revision Tip**

> Although VWAP is useful for liquid, non-trending markets, implementation shortfall is generally superior when minimizing the impact of delay and missed trade costs matters, especially for large or illiquid trades.

### Attribution and Use in Evaluation

Post-trade TCA breaks down costs into components—spread, impact, delay, opportunity cost—enabling teams to review each step of the execution and diagnose process weaknesses.

### **Worked Example 1.3**

You submit a large market order and obtain execution at a price 0.6% worse than the decision price, incurring \$3,000 in commissions for a total trade size of \$800,000. The post-trade TCA finds 40% of this total cost is spread, 30% market impact, 10% delay, and 20% opportunity cost due to partial fills. What management actions might follow?

> **Answer:**
> The desk could focus on alternative order types or liquidity sources, such as dark pools or crossing networks, to reduce spread and market impact. Adjusting the order algorithm to better match market conditions may also lower delay and opportunity costs.

### **Exam Warning**

> CFA exam questions may trick you by providing transaction cost figures that omit missed opportunity cost or use only VWAP. Always consider all four cost components—spread, impact, delay/slippage, opportunity—and know when implementation shortfall is the most informative measure.

## PRE-TRADE VS. POST-TRADE TCA: PRACTICAL COMPARISON

| Feature        | Pre-Trade TCA                  | Post-Trade TCA                                          |
| -------------- | ------------------------------ | ------------------------------------------------------- |
| Timing         | Before execution               | After execution and settlement                          |
| Data required  | Historical, estimated          | Actual execution and market data                        |
| Main purpose   | Cost forecasting, strategy     | Performance evaluation, attribution                     |
| Typical users  | Portfolio/trading managers     | Compliance, risk, trading desks                         |
| Key components | Spread, market impact, urgency | All implicit and explicit costs, incl. opportunity cost |

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Differentiate and explain explicit and implicit transaction costs
- Define and compare pre-trade and post-trade TCA for portfolio decisions
- Calculate and interpret implementation shortfall and VWAP benchmarks
- Understand how market microstructure (order types, liquidity, information flow) shapes trading costs and strategy
- Recognize practical uses of TCA for performance measurement and process improvement

## **Key Terms and Concepts**

- market microstructure
- explicit costs
- implicit costs
- transaction cost analysis (TCA)
- pre-trade TCA
- post-trade TCA
- implementation shortfall
- VWAP

Market microstructure and costs - Pre-trade and post-trade tca