High speed automated market may increase concerns about buyback costs.
Dark pools, high-frequency trading, VWAP algorithms, order types, alternative trading systems—if corporate treasurers are uncertain about those terms, it’s unsurprising given the equity market’s profound changes in recent years. Regulators are now stepping in to provide market participants with more clarity and visibility to understand the cost of their trades.
Treasurers attending a NeuGroup peer group meeting late last year asked invited experts giving a presentation on repurchasing shares to explain the workings of dark pools. This was interesting given that dark pools have played an important role in executing orders to repurchase shares for several years now. In fact, it became all too clear just how little they knew about the structure of today’s equity market, which has changed dramatically since the late 1990s.
The 2010 Flash Crash, in which the Dow Jones index dropped a thousand points within minutes, and more recently Michael Lewis’ Flash Boys: A Wall Street Revolt, have prompted jitters about the equity market’s fairness among investors and issuers. Probing brokers about their trading strategies, and that of their trading oriented customers, is the first step issuers must take (See “Well-Vetted Buyback Programs Can Save Money,” and new regulations, many currently in the works, should give treasury executives new insight into their brokers’ trading strategies and the quality of their trades.
“The executions of the liquid stocks [of large companies’] are usually pretty good, but there are a lot of people along the way who are picking the pockets of corporate treasuries. The problem with going to a traditional sell side firm is it’s not clear what they’re doing with the order information once you give it to them,” said David Weild, founder and CEO of Weild & Co., an issuer-aligned investment bank.
A former vice chairman of Nasdaq, Mr. Weild was instrumental in the passage of the JOBS Act in 2012, which facilitates smaller companies’ access to capital. In support of the legislation, he argued in Congressional testimony and elsewhere that modern market structure, including quotes in penny increments rather than the previous eighth of a dollar, made it uneconomical for Wall Street firms to support traditional stock activity, including IPOs, research and sales calls to long-term investors, with traditional market making. Designated firms that kept orderly markets and committed capital to support transactions became unviable.
As a result, trading has been taken over by highly automated firms that seek to trade on forecasted order flows rather than the fundamentals of the issuer’s business, and without the orderly-market obligation. The sophisticated trading programs of high frequency trading (HFT) firms in particular can identify large orders seeking execution, including those supporting a share repurchase program. If the broker pursues inadequate strategies to disguise the order, opportunistic trading firms jump ahead to buy up shares, increasing the share price and cost to the company pursuing the repurchase.
Mr. Weild noted that the cost of trade may simply tally the broker commission and the narrow bid-offer spread, typically a few pennies for a liquid stock, which the broker captures. That cost has fallen dramatically over the last 20 years, but the absolute cost, if opportunistic traders drive up the share price, can be much more.
“It really doesn’t matter if you paid two cents to execute a share if the stock price has increased by a dollar a share,” Mr. Weild said.
Putting the genie back into the bottle will be difficult if not impossible, given the fundamental changes that have taken place on Wall Street. Nevertheless, regulators are pursuing a wide range of initiatives that are intended to stabilize the market as well as give issuers greater transparency into their brokers’ trading strategies. They will also create more transparency around the workings of today’s market structure, improve liquidity and the quality of the executions supporting their stock repurchases.
On the liquidity front, Mr. Weild pointed to a pilot approved by the Securities and Exchange Commission (SEC) last May to test increasing the quoting increment, or tick size. Implementation of the pilot is anticipated to begin in the fall, although because of delays it is still unclear what the pilot will look like. The initiative will mainly impact smaller issuers, although the data derived and lessons learned from this pilot will likely be used to inform market participants about market structure more broadly.
Other regulatory initiatives aim to provide market participants with a better understanding about how the equity market works today, and more transparency into the cost effectiveness of their brokers’ trades.
For example, in November the SEC recommended a rule to amend registration requirements for alternative trading systems (ATSs), including dark pools. Sayena Mostowfi, principal, head of equities research at Tabb Group, noted that exchanges must file to get approval for every type of order they offer market participants to trade, as well as their different methodologies to match orders.
ATSs, executing approximately 15% of trading volume, “haven’t had to file such granular information about how their matching systems operate,” Ms. Mostowfi said.
In a report published in January titled “2015 US Equity Market Review: Objects May Be Further than They Appear,” Tabb Group says that the rule would require ATS platforms to detail the broker-dealer’s affiliates and operations and make the forms publicly available. Brokers are required to seek best execution for their clients, but they may post orders in dark pools favorable to them from a cost perspective, including their own dark pools, to wait for a match. This rule could help market participants more easily identify such conflicts of interest.
“With the additional disclosures in 2016 from both ATSs and exchanges comes greater responsibility for market participants, including the buy-side and the sell-side, to distill, analyze and act on new information in order to provide best execution to customers,” the report says.
To analyze such data effectively requires expertise on equity market structure, and institutional investors tend to use third parties such as Tabb Group and Able/Noser to analyze broker trades, execution quality and cost. Corporate treasurers running significant repurchase programs may also want to tap third parties, whose analysis will likely benefit from the additional information the proposed regulations promise. The new information should also give treasury staff extra ammunition in their own analysis of trade quality.
“Corporate treasury would benefit from transaction cost analysis from a third party,” Ms. Mostowfi said.
Starting in April, the Financial Industry Regulatory Authority (FINRA) will publish share and trade data at a firm level for most non-ATSs, providing market participants with more insight into where brokers are executing orders supporting buybacks. In addition, FINRA is anticipated to propose a new rule in 2016 to publish statistics for large block trades executed on ATSs.
New light will also be shed on many of the large high frequency trading firms that trade on a proprietary basis and whose algorithmic trading applications have raised concerns about fairness. Those firms will have to register with FINRA and comply with its rules, including a rule the regulator is pursuing that that would require registration of persons involved in the design, development, or significant modification of algorithmic trading strategies.
Although that information likely will stay with the regulator, registration may serve to dampen traders’ enthusiasm for creating highly aggressive and potentially problematic trading strategies.
Last year, the SEC announced members of the Equity market Structure Advisory Committee, a cross section of the market representing institutional investors, brokers, academics, and technology vendors. The goal of the committee is to provide diverse perspectives on US equity market structure, leading to recommendations. So far, however, there’s no one representing issuers. Nevertheless, corporate treasury executives may want to pay attention to its progress.
“With the current committee members’ terms ending in 2017, they will be under pressure to develop specific action items in 2016 with their remaining time in office,” the Tabb report notes, adding that the next meeting is Feb. 2.
In the wake of the Flash Crash and numerous instants of significant market volatility since, regulators more urgently sought ways to stabilize the equity market. In an earlier report published in October 2015, Tabb Group provides a lengthy list of regulatory actions that have been approved over the last five years. Many of them give exchanges more ability to deal with trading techniques that can result in volatility, such as “clearly erroneous trades” and “stub quotes.”
The Market Access rules, approved several months after the flash crash, essentially require brokers to bolster their risk management systems and to keep a closer eye on potentially problematic customers. Improved market-wide circuit breakers were introduced.
“Until the May 6, 2010 Flash Crash, the regulators were focused mainly on market competition, and now the pendulum is shifting to how we can make this complex market structure more stable and transparent,” Ms. Mostowfi said.