Magazine for Senior Financial Executives: Click for Cheaper Capital – cost savings derived from automated trading

Click for Cheaper Capital – cost savings derived from automated trading – Brief Article

John P. Mello

THE BOTTOM LINE:. Savings derived from automated trading often translate into lower capital costs.

A pair of professors at the Smeal School of Business Administration at Penn State University are supplying more ammunition to the forces lobbying for greater automation of stock trading. The duo, Ian Domowitz and Benn Steil, have studied the impact of transaction fees on the cost of capital for firms, and conclude that automated trading reduces capital costs substantially.

The prevailing wisdom is that high expectations for the market drive up price/earnings ratios, thereby reducing the cost of capital, says Domowitz. “But to us, that’s only half the story.”

The researchers discovered that when automated trading is used on the major exchanges, transaction costs–including fees and market impact–drop by as much as one-third. Those savings can be directly translated into lower capital costs, the two assert. For every 10 percent decline in trading costs, the cost of equity capital to blue-chip listed companies slips 1.5 percent, they say. From 1996 to 1998, trading costs dipped 53 percent in the United States, which resulted in an 8 percent tumble in the cost of capital for S&P 500 companies.

Why do the transaction and capital costs fall together? “If a company’s fundamentals remain constant, you’ll see a lower cost of capital for a liquid stock,” says Domowitz, “To me, a more liquid stock is one I can trade more cheaply.”

Fully automating the major exchanges, however, is still only a utopian dream. “The exchanges have tried to enhance floor trading by incorporating electronic solutions, but they still have a lot to do,”. says Dorit Zeevi-Farrington, vice president of trading research for New York-based Instinet, an electronic communication network for stock trading. “You have constituents there, you have traditional specialists making money off these trades, so that makes it hard to move off floor-based trading to complete automation. As this is a zero sum game, a lot of people have a lot to lose by doing that.”

COPYRIGHT 2001 CFO Publishing Corp.

COPYRIGHT 2001 Gale Group