Old rules, algorithmic traders add costs to U.S. share buybacks

[April 27, 2018]  By John McCrank

NEW YORK (Reuters) - U.S. companies are on track to buy back a record amount of their own stock this year, but a decades-old markets rule aimed at preventing manipulation makes these trades easy to game and has probably cost companies billions in recent years.

Stock buybacks were banned in the United States until 1982, when rules were set as to how companies could repurchase their shares without falling afoul of anti-manipulation provisions.

But the "safe harbor" rules have not been revised since 2003 and critics say they do not reflect the electronic, fragmented nature of today's markets, which makes share repurchase orders easy to spot and trade in front of by high-speed trading firms, leading to higher prices for companies that buy back stock.

"Everybody knows there is a corporate order flow so they front-run it and that just pisses me off because they will raise the price high enough where then they will sell it back to me. That's just not fair," Gary Barth, assistant treasurer at United Parcel Service Inc <UPS.N>, told Reuters.

UPS has a $1 billion share repurchase program in place this year and has bought back around $15.3 billion of its own stock since 2012.

Under a condition of the U.S. Securities and Exchange Commission's Rule 10b-18, companies must bid to buy back their stock at the last purchase price set by another investor or at the best bid available in the market. But they cannot buy shares at the best offer available, because that could cause the company's shares to move and be deemed manipulative.

Given that companies must announce their repurchase plans, the restrictions make it easier to detect stock buyback activity, said Ted Morgan, chief executive officer of brokerage Abel Noser, which executes share buybacks on behalf of corporate clients.

"It's a lot easier than it is to detect other types of institutional flow," he said.

Since 2010, S&P 500 companies have spent nearly $4 trillion on share buybacks, according to S&P Dow Jones Indices. (Graphic: https://tmsnrt.rs/2vOQDwm)

Based on buyback announcements so far, 2018 repurchases are expected to "smash totals from all other previous years" in the wake of the tax-cut bonanza companies received under the Trump administration, according to research firm TrimTabs.

There are no estimates how much high-speed traders make, but even if the difference in price is mere pennies, exploiting the buyback vulnerability can translate into huge profits, while doing nothing for others in the market and effectively forcing companies to waste some of the buyback money because they cannot mask their activities.

FLASH BOYS PETITION

Exchange operator IEX Group has petitioned the SEC to let firms buying back shares do so using hidden orders that only execute at the midpoint between the best bid and the best offer. That would make it difficult to move the stock price while making the activity harder to spot.

A trader works on the floor of the New York Stock Exchange in the Manhattan borough of New York City, New York, U.S., April 19, 2018. REUTERS/Brendan McDermid

"The change we are arguing for could save public companies millions of dollars or more in execution costs," IEX CEO Brad Katsuyama said in a statement to Reuters.

The share buyback petition is the latest cause taken up by IEX, which launched its exchange in August 2016 and was earlier featured in Michael Lewis's book "Flash Boys: A Wall Street Revolt," which followed Katsuyama and his colleagues as they set out to create a market that they saw as fairer to investors.

The exchange features a so-called speed bump that slows down trades to prevent the fastest traders in the market from trading ahead of slower investors. Like other exchanges, and private markets known as dark pools, it also features midpoint order types.

Because those order types are hidden, it would make it much more difficult for trading firms' algorithms to spot buyback trading patterns, accumulate the shares and then sell them back to the issuer at successively higher last sale prices.

The SEC declined to comment on the petition, but had itself suggested allowing midpoint share buybacks in 2010 as part of a proposed revamp of the safe harbor rules.

But the proposal was dropped in the wake of the May 2010 stock market flash crash, which, along with Dodd-Frank rule making following the financial crisis, overwhelmed the regulator's resources.

Eight years later, UPS's Barth said he is still waiting for the SEC to take action.

Current SEC Chairman Jay Clayton said on April 10 that the regulator "should listen to investors and market participants about where Commission rules are, or are not, functioning as intended," and do retrospective reviews on those rules.

"The time has come," Barth said. "They still haven't done anything. Come on guys, help a poor guy out here. Let's get into the 21st century!"

(Reporting by John McCrank)

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