In a world of dark pools, hidden reserves and blind crossing networks, the business of trading in your company’s shares has morphed into something closer to high-energy physics than the simple buying and selling of days gone by. At any given moment, your shares can now find new homes at lightning speed.
‘Our clients are concerned about milliseconds or even microseconds,’ says the NYSE’s Mike Cormack, executive VP in charge of development. One trader tells of moving his computers from the Carolinas to New York to shave 15 microseconds off execution times.
This is the new equity marketplace, where stocks trade at the speed of light through computerized systems festooned with algorithms. No, this is not your grandfather’s or even your father’s stock market. According to the Tabb Group, around 52 percent of all institutional trades were routed electronically last year. Tabb predicts the number will increase at a blistering pace, reaching 80 percent of total order flow next year, according to its survey of buy-siders.
What does this mean for investor relations? Trading is one thing and dealing with shareholders is another, but one impact is related to the fact that very large blocks of shares can change hands instantly and almost invisibly. Most experts say electronic communications networks are positive because they can allow an institution to build or divest a big stake without disrupting the market.
Increasing value
Professor Richard Green of the Tepper School of Business at Carnegie Mellon University points out that innovations in the marketplace benefit shareholders by lowering transaction costs. ‘Increased transparency and liquidity are good things,’ he says. ‘Executives should be supportive of these developments because they increase the value of the shares.’
The systems at play may appear mysterious because they often hide the movement of money managers either out of or into a large stock position. Anonymity is crucial to maintaining price stability, and the old method of asking a broker to handle trades with secrecy has now been supplanted with new tools operating at much higher speeds. That said, once completed, all trades must be reported and all required audit trails must show participant names.
The new tools bring with them a number of suspicioussounding terms. Blind crossing networks are computer systems that allow you as buyer or seller to stay anonymous while also oblivious to who is on the other side of a trade or what size their interest may be. These networks match bids and offers. Hidden reserves are the shares you have ready to move, but which stay obscured while the systems mete out small trades, not giving your intent or presence away and helping to maintain price equilibrium. And dark pools? They are simply more of the same, often aggregated so that streams of stock orders become pools of liquidity. Trading takes place behind the veil of internal crossing networks or specialized exchange platforms where the pools build up, and activities are held private until all the trading that is to be done is actually executed.
Secret trading
With all this explained, what is there to worry about? The regulators seem fine with it all. The SEC notes that rules for disclosure of ownership are well established and carefully monitored. Regulations call for public filings to be made when low ownership thresholds are crossed. A spokesman for the SEC says staff are constantly on the alert for problems.
Reporting is not a real-time process, however, and there are a few tears in the fabric of disclosure, including the fact that hedge funds do not have to report their ownership of stock. Likewise, it is possible that the reports will end up delivering incorrect information.
‘The person who shows up on the 13F report may just be a person who the shares are passing through,’ according to Bill Jenks, New York partner at London-based investor relations adviser Makinson Cowell. An investment bank that looks like a typical investing institution, says Jenks, may simply be working a complex deal that requires it to have the shares in hand for trading purposes. In disclosing this type of working position on the 13F, incorrect information can get to the company keeping track of its ownership. ‘You get a false positive,’ Jenks says, ‘and a false negative, in that the real holder doesn’t show up anywhere.’
The rapid increase in computerization has other ramifications. ‘Your shareholder base can change with lightning speed,’ according to David Drake, senior managing director of proxy solicitor Georgeson Shareholder. ‘You may think you have a shareholder base that’s populated by long-term institutional inventors, only to find out – maybe during the course of a proxy fight or contest for control of the company – that your shareholder base has changed substantially and that you have a majority of investors with very shortterm investment horizons.’
Merging worlds
This secular compression of trading caused by computerization has played a seminal role in the recent combinations of the NYSE with Archipelago Holdings and Nasdaq with Instinet’s trading division. Essentially, the two traditional exchanges have gone from accommodating the computerization trend to obtaining full turnkey capability for program trading and crossing networks.
These mergers respond to expanding off-exchange trading and are designed to capture new market share. But what are the implications of all this for listed companies?
‘There are more venues than there were ten years ago,’ observes Green. But there are countervailing forces, such as the merger of Euronext and NYSE, he adds. ‘There is this ebb and flow that is going on, and it’s not clear how things are going to end up. Whether it is good or bad is hotly debated; we’ll learn a lot over the next five years.’
While the outcomes are open to debate, the overall effect of computerization is a plus for corporate shareholders because it trims costs. David Whitcomb, founder of Automated Trading Desk, charts the changes. Back in the 1970s, the spread between bid and ask was wide – Whitcomb calls this gap the ‘invisible cost’ of a transaction, because the ultimate shareholder doesn’t see it.
Over time, as regulators forced market-maker quotes to be disclosed, spreads began to fall. Further regulation led to reductions of share quotes from increments of eighths of a dollar to 16ths, and ultimately to one cent. ‘It used to cost 25 cents a share on Nasdaq just ten years ago,’ Whitcomb notes. ‘Now it’s just a penny.’
Easy money
The effect of automation has been to radically reduce the cost of trading for individuals as well as institutions. Companies issuing new stock or buying back what is out there will realize these cost savings too. ‘If you can reduce the cost of trading for everyone who trades, it should benefit shareholders because that’s basically money they would have spent,’Whitcomb says.
Corporations can get quite tied up in tracking day-to-day or even minuteto- minute gyrations in stock prices, something another adviser to boards and CEOs says is probably not warranted. ‘I try to get my clients off the idea that what is going on with their stocks is all machinations behind the scenes from naked shorts or exotic hedge fund strategies,’ says Alan Oshiki at Broadgate Consultants, part of proxy solicitation firm DF King. He sees market inefficiencies as very short-lived and says trading systems aren’t to blame.
‘There’ll be a blip, but your stock doesn’t fall 20 percent and then stay there because somebody is short or because there are large volumes trading away from the floor,’ Oshiki says. ‘The markets are generally more efficient than that. Where they tend to be inefficient is where there is a basic misunderstanding about the company or just a perception in the market that management doesn’t believe or can’t change.’
Sounds like familiar territory for IROs, who often have to change viewpoints both inside and outside the company. Trading, while faster and more complex than ever, is ultimately responding to sentiment, not creating problems for corporations. ‘My experience has been that any long-term impact is generally due to fundamental things like market perceptions, as opposed to real trading activity,’ Oshiki says.
So the message is, don’t get too wrapped up in the mechanics of trading as it affects day-to-day share price movement. As for the macro effects of all the structural change on your company’s capital-raising efforts, ‘watchful waiting’ would appear to be your best bet.
