Hong Kong Exchange and Clearing (HKEx) could reinstate a closing auction next year, according to market participants who have been consulted on possible alternatives to the current method.
HKEx abandoned its previous closing auction process in March 2009, after a 12.5% drop in HSBC shares during the 9 March closing auction was widely regarded as the result of market manipulation.
The current procedure – whereby the closing price for stocks is calculated as an average of five price snapshots taken during the last minute of the continuous trading session – has been criticised for placing excessive pressure on HKEx's trading system.
The absence of a standard auction mechanism can be problematic for mutual funds that want to determine the net asset values for their investments at the end of each day, but may not be such a problem for active investors.
“The closing auction as it was run previously meant the Hong Kong market exhibited a high level of price volatility towards the end of the day,” said Kumiko Oe, head of Asian trading at AllianceBernstein. “The current snapshot method does not really have an impact on firms that run active funds, and is more of an issue for passive funds that require closing prices for valuations.”
As such, Oe stresses that most investment managers would want any new closing auction solution to be stable and safe from market manipulation, to avoid disadvantaging the whole market.
As part of an update to its three-year strategic plan for 2010-2012, HKEx announced at the beginning of this year that it would “explore possible options to enable execution at market close in view of market needs and based on its experience”. But the exchange has declined to comment on discussions with market participants and its trading members.
Most larger brokers have adopted a workaround solution to the current closing procedures by using algorithms that increase order sizes sequentially as the market close draws nearer. This increases the likelihood of achieving a final price that is near to the closing price. However, to ensure market impact is kept to a minimum, brokers' closing algorithms may start just before the snapshot closing method commences in the last minute of continuous trading.
Up to capacity
According to Gabriel Butler, director, sales and execution, Asia-Pacific, Bank of America Merrill Lynch, the prevalence of such algorithms near the close can cause the HKEx trading system to hit its capacity limits.
“The Hong Kong market can be slower in the last few minutes of the day leading up to the close,” he said. “On a high volume day, you could put an order to the exchange in the last couple of minutes and face a delay in getting executed because of the backlog of traffic. If all orders were traded in an auction it would undoubtedly increase market efficiency.”
Butler adds that the current closing process can be difficult to handle for smaller Hong Kong brokers that do not have the capabilities to trade algorithmically. Given that HKEx is currently working towards the introduction of a new version of its trading system – called AMS3.8 – before the end of the year, Butler anticipates that a closing auction could be reintroduced during 2012.
Potential options that may be under consideration by HKEx include establishing a closing auction that begins as soon as continuous trading ends – similar to the procedure in Australia and Singapore – or overlapping the auction with the end of the trading session.
The latter would allow brokers to submit auction orders during continuous trading, enabling them to get an indication of the prices and volumes that will be available in the auction.
But Butler adds, “Overlapping continuous trading and the auction works best in markets with a high level of automation, because trading decisions need to be made quickly. Because many Hong Kong brokers don't have algorithms to trade efficiently, the exchange is more likely to implement an auction mechanism that operates after the end of continuous trading, perhaps similar to those in Singapore and Australia.”
Another option that could be considered by HKEx is an approach that bases closing prices on a VWAP calculation across the last 30 minutes of continuous trading.
“The closing mechanism in India could be a good alternative for HKEx to consider,” said one source at a large broker. “It would use a familiar benchmark and would give the market enough time to react to an adverse price move, especially if the price limits for closing prices are implemented.”
HKEx's three-year strategic plan was first announced in March 2010 by incoming CEO Charles Li. It was devised to help the exchange adjust the developing competitive landscape and enable it capture more business in mainland China.