As 2019, and indeed the decade, draws to a close, buy-side traders and market operators across Europe have been adapting to a recent trend which has made the final phase of the trading day the most crucial by far. In what is often referred to as a ‘unique liquidity event’, national stock exchanges conduct a five-minute closing auction session after continuous trading has ended, during which the fundamental process of establishing fair closing prices on securities is carried out.
While some traders consider the closing auction to be a ‘safe haven’ in terms of gaining that official closing price, others are uneasy about the trend’s impact on intraday liquidity and continuous trading.
Around three years ago, closing auction volumes in major indices across Europe accounted for approximately 16% of total order book volume, but now closing auction volumes consistently account for more than 20%. The development is more noticeable in some European markets than others. In France, for example, data from the Autorité des Marchés Financiers (AMF) revealed that volumes of shares traded in closing auctions has climbed from between 20% and 28% through to 2015, to a significant 41% traded on Euronext Paris for CAC 40 stocks in June 2019.
While closing auctions are operated exclusively by the European national exchanges, such as the London Stock Exchange, Euronext and Deutsche Börse, the industry has seen other operators bring forth new functionality, order types and mechanisms in a bid to introduce greater competition in the space, while helping market participants engage and interact with the increasingly crucial liquidity at the close.
It’s important to note that the amount of total volume in closing auctions is not increasing, but the percentage of total volume has increased dramatically. This has sparked concern from some senior traders, particularly those among active buy-side firms, who largely agree that trading during the day has become more difficult as a result.
“This shift has been driven by passive exchange traded funds (ETFs) and index tracking volumes aiming to benchmark at the close. These funds just need to achieve the closing price for valuation purposes with creations and redemptions,” says Daniel Nicholls, head of trading at Hermes Investment Management. “It is not unusual for stocks to spike in the closing auction then reopen the next day at the previous level last seen in continuous trading. This isn’t healthy, as it isn’t a reflection of where valuations have been throughout the trading day.
“If real volume continues to shift to the close, what will be left in continuous trading? We could see increased toxic market making and front running by high-frequency trading (HFT) firms. The amount of negative reversion has already increased significantly due to the lack of liquidity during continuous trading.”
Market commentators generally agree that the shift from active to passive investing and ETFs has been a key driver of the move towards the close. The closing auctions are used by active funds, but for passive funds that track major benchmarks, trading in closing auctions is imperative in acquiring that closing price.
Alasdair Haynes, CEO and founder of Aquis Exchange, one of the market operators that has introduced an alternative closing auction mechanism in Europe, also points to other trends in the market that have caused the percentage of volumes to move so dramatically from continuous trading to closing auctions, although he argues it remains unclear exactly what has driven the shift.
“The problem is nobody out there can actually tell you whether this trend is structural or cyclical,” Haynes says. “What we do know is that more business is being conducted in the close than ever in the past, and to a level whereby it is getting significant and, in some ways, the trend is probably not healthy for the market. Is this passive trading which demands the closing price? Frankly, I don’t buy that argument. I believe it is a combination of different things, some which are structural and some which are cyclical.”
The cyclical part which Haynes refers to is a clear reduction in total volumes across the European equities trading landscape this year, including in the closing auctions, as a seemingly relentless risk-off sentiment continues to dominate the market. David Howson, chief operating officer at Cboe Europe, which has also launched an alternative closing auction mechanism, adds that the combination of low volumes, volatility and the rise of passive investing has made it challenging for traders to execute during the day, particularly larger sized trades.
“Over the past 12 months, the risk-off environment that markets have endured due to uncertainties around Brexit and trade wars has caused volumes and volatility to decline, creating much thinner markets intraday on the lit books,” Howson comments. “That leaves less room to transact large positions intraday, which means more participants turn to alternative mechanisms and ultimately closing auctions to execute their trades.”
Liquidity begets liquidity
As the volume profile of the market has changed, so have the volume-profiling algorithms. The volume-weighted average price (VWAP) algorithm, for example, maps distribution of liquidity throughout the day to an order, meaning as volumes in the closing auction increase, the more the algorithm will route orders there. Essentially then, algorithmic trading is accelerating the shift to the close. As the concentration of liquidity and volumes in closing auctions has become more prominent, buy-side traders have adapted strategies as intraday liquidity has become harder to find.
“This has been an important for us because we have been adapting to it quite recently,” says Eric Champenois, head of the trading desk at asset manager Unigestion. “There is not much volume in the morning now, so we tend to be more passive during that period than previously and our volume participation during these hours has been impacted. It’s mostly a negative development for investors because for at least fifty percent of the trading day it’s difficult to find proper liquidity.”
It’s a case of liquidity begets liquidity. As volumes are forced to the end of the day, the closing auctions are fast becoming the only place to execute in size in the market today. When news or information comes out, it’s important that traders have the ability to engage in continuous trading, but as the buy-side struggles to interact with intraday liquidity, the market has had to hold positions to trade at the close, which is not considered to be a positive development for investors. The ability to offload risk throughout the day is considered a strong sign that a market is well-functioning.
Hermes’ Nicholls echoes Champenois, adding that the migration of volumes to the close is even more problematic for traders that have different benchmarks due to subscriptions and redemptions in the fund. If money hits a fund, a trader will be looking to transfer the money into equities as soon as possible. Traders can’t sit on an order for an entire day before placing it in the closing auction, and even then, they risk losing out altogether due to the uncertainty of execution and price at the end of the day.
“When money arrives into the fund it hits at different times of the day, the trader has to aim to transfer that money into the price of equities at that time to minimise slippage,” Nicholls says. “The prices in the closing auction can be wildly different, good or bad, and if you use the closing auction but don’t get what you need to done, then it can be really problematic because the market’s closed. It has led to thinner volumes during continuous trading and increased intraday volatility, which is bad news as it precipitates an instable market because price formation is unreliable.”
For market operators such as Cboe and Aquis Exchange, this has been an opportunity to help traders interact with liquidity at the close more efficiently. Cboe confirmed plans this summer to launch Cboe Closing Cross, or 3C, as an alternative closing auction mechanism that crosses orders every minute during a 45-minute window once continuous trading ends at 4.30pm in the UK.
3C targets the surplus and non-price forming flow that can’t access other alternative at close mechanisms. It does not import or reference the official closing price, something Cboe’s Howson says was a strategic move by the exchange, as the regulatory debate around current market data pricing continues to loom over the European equities landscape.
“We didn’t want to be beholden or vulnerable to the market data license costs of the national listing exchange,” Howson explains. “Some of the existing models out there rely on importing that price from the listing market, and if you have a model that relies on that then there are risks around data, auction extensions and other issues.
“We are not aiming to attract or undermine the price forming process done in the listing market closing auction as everyone accepts that is an important benchmark pricing event. With 3C we are really looking to attract the non-price forming flow. The beauty of 3C is that is allows a ‘one-stop-shop’ for market participants to trade at the price they wish to trade across 18 markets. There’s flexibility and freedom with the at limit order and there is no lock-in, which is interesting to market participants because we understand that things change and people change their minds.”
As Howson mentions, 3C operates an ‘at limit’ order type, meaning the order will only be executed at the price specified or not at all. The order type gives traders the ability to choose what they think is the right closing price, and trade it with certainty. Although as Hermes’ Nicholls alludes, the ‘at limit’ order could create risk that some traders will miss out completely if they don’t get the limit price.
“You have to be prepared to accept the uncrossing price in the closing auction by using an ‘at market’ order, because with an ‘at limit’ order you risk missing out entirely,” he says. “There is also a risk that the closing auction price is not an accurate reflection of where the market has been during continuous trading, because it can be heavily skewed by buy/sell imbalances. The trader has to surrender a degree of control and take the closing price the market uncrosses at if they have to be filled. Any surrendering of control produces an increased risk.”
France’s AMF conducted its own study on the rise of closing auctions earlier this year, focusing on the trend’s potentially detrimental effect on price formation. While it did not find definite proof that the rise of closing auctions undermined prices during the day, the AMF did flag increased potential for ‘flash crashes’ and operational risks for traders engaging in increasingly large end of day trading sessions.
In one example, the AMF referenced an incident in May 2018 whereby a trader wanted to execute a buy/sell-back transaction on 3.5 million shares, but triggered Euronext’s circuit breaker. The trader tried to reduce the size to 2 million shares, but only had time to enter the buy order. The error resulted in a ¤2.2 million loss, with multiple market participants impacted by the event.
Aquis Exchange launched its own alternative closing auction mechanism in 2016, but has only this year gathered substantial interest from the market in light of the shift of activity towards the close. Known as Market at Close, or MaC, the mechanism allows traders to execute orders at the official closing price only.
Aquis founder Haynes says it is the only European exchange importing the official closing price of the listing-exchanges across the region in a bid to establish and create liquidity. But, perhaps more importantly, MaC aims to reduce costs for market participants and bring competition to the market which national exchanges have retained a monopoly over. Cboe’s 3C mechanism is also free to use until 1 July 2020, which Howson says was a strategic move to encourage competition in the space, but to also show traders that engaging at the close doesn’t always have to cost more.
Healthy competition in the European equity market is important in terms of ensuring services are well-priced and innovative, but as closing auction volumes are concentrated on just a few venues in Europe, some exchanges have seized the opportunity and raised prices for participating in end of day trading.
“The product is all about reducing costs whereas almost every other product we have is about enhancing liquidity. Getting the same for less is a very attractive result, and that’s what is important about this,” Haynes says. “I really don’t like the fact that [national exchanges] have a complete monopoly on what the official closing price is, given the fact that the market is healthily fragmented, in my opinion, to have competition whereby prices, spreads and costs of trading have all fallen over the past few years. There should be competition at the close, and that shouldn’t be just about the price. Everybody who has significant liquidity at the close should be pooled together to create a better closing auction which involves all parties concerned in the industry.”
There are some advantages for traders using the closing auctions and, of course, they have been a positive development for the industry in terms of proper price discovery and valuing funds correctly. Trading in closing auctions can also remove the ‘crossing the spread’ cost of trading for both the buyer and sellers as they meet at the same price.
However, it is unclear how much more volumes will shift to the end of the trading day, and with the effects of the trend already being felt on the buy-side trading desk, it is clear why market participants are expressing concern on the subject.
At the same time, the monopoly that national stock exchanges hold over the closing auction and the official closing price adds to the complex debate. After all, it does seem strange that as the industry benefits from having strong competition and multiple venues for trading intraday, there is just the one venue for the close.