In London, the trading day begins with a flourish when markets open at 8am, slows down until the US wakes up from about midday, and then dithers its way to the final minutes of the session.
Thanks to passive investing, however, the closing auction — a window of just five minutes — is becoming the most heavily traded part of the day, a shift that has driven a wedge between investors, banks, exchanges and regulators.
Stock exchanges’ so-called closing auctions set the official closing prices for shares. According to analysis by Goldman Sachs’s quantitative execution services division seen by Financial News, closing auctions in Europe, the Middle East and Africa accounted for 25% of daily volumes in the first quarter of 2019, versus 19% in the corresponding period the year before.
The Autorité des Marchés Financiers (AMF), the French regulator, said closing auctions represent 40% of all transactions on Euronext Paris.
The focus on closing auctions comes as passive investment strategies in Europe soar towards €1tn in assets. Low-cost exchange traded funds hold baskets of shares designed to mimic the performance of an index or benchmark, and the prices passive investors around the world rely on to benchmark their funds are set in stock exchanges’ closing auctions.
Some investors welcome the volume because it practically guarantees them liquidity and makes trading easier. But others grumble that exchanges charge more to trade during closing auctions, and regulators are concerned that closing auctions threaten markets’ safety.
In its annual risk assessment on July 2, the AMF warned of the potential for greater volatility during the day and even so-called flash-crash events, when markets can go from calm to chaotic and back in an instant.
The regulator also said the shift risks a “deterioration” of price formation, the process through which prices are determined efficiently. AMF chairman Robert Ophèle told Financial News the regulator’s stance is to “monitor as closely as possible but to refrain from reacting too swiftly”.
Debate about the closing auction is only going to get louder. Passive investing is tightening its grip on markets, with assets shifting into cheap exchange traded funds that aim to track indices instead of beating them. Active managers, which try to beat the market, are suffering. According to Morningstar, the data provider, the ETF sector in Europe could hit €2tn of assets by 2024, from €760bn in March this year.
The volume surge is particularly pronounced in Europe. Goldman Sachs’s GS, -0.27% research found that the US equivalent of the closing auction had been comparatively stable, rising from 12% to 14% of daily volumes.
One driver that has led the auction to become especially important in Europe is the rules that came into force at the start of 2018. Traders say the EU’s revised Markets in Financial Instruments Directive has made buying and selling stocks much more complicated.
Where once the vast majority of the available liquidity was on national exchanges, it is now fragmented across numerous exchanges, venues and brokers, which can make the process of matching buyers and sellers less likely.
Traders taking advantage of the closing auction’s increasing popularity can post orders at the close, knowing that it concentrates a flurry of buying and selling activity in a short time frame, increasing the probability of getting a deal done. And as the AMF points out, executing trades at the close simplifies certain required reporting.
Brian Schwieger, global head of equities at the London Stock Exchange LSE, +0.42% , said cultural differences between Europe and the US also explain the magnitude of the trend. A former trader at Bank of America Merrill Lynch BAC, +2.09% and Morgan Stanley MS, -1.19% , Schwieger said investment managers in Europe were historically more inclined to call banks to buy or sell a large block of shares on their behalf.
Regulation and capital requirements have damped banks’ appetite to take those risks. Another factor is that the US is awake and trading during European closing hours, widening the number of participants, he said. When US markets close, European and Asian investors are typically offline.
Schwieger said: “When are most money managers awake at closing auctions? It’s Europe. You have much more money available to put into the closing auction in Europe than any other regional closing auction.”
The concentration of trading in the closing auction has not been purely advantageous for traders, as some exchanges charge a premium to trade in it. Unlike trading throughout the day, where rival venues compete hard for volumes, the closing auction has remained lucrative for national stock exchanges.
One broker estimated that exchanges can make between 28% and 47% of total trading revenues from the closing auction, though others say the fees are obscured by tiered and complex charging models.
The Euronext Paris ICE, -0.66% and Nasdaq Stockholm NDAQ, -0.35% exchanges confirmed that traders can be charged more to participate in the closing auction than at other times of day. A Nasdaq spokesman said that although its variable fees are higher in the auction, the costs for traders choosing the closing auction can ultimately be lower, depending on the size and nature of the order. A Euronext spokesman said members “can choose from several pricing models to best fit their needs”.
Joelle Tarrant, head of market structure at HSBC HSBC, -0.41% , the bank, said the closing auction “creates a catch-22. It’s incredibly useful to have a guaranteed deep pool of liquidity at the end of the day. However, it can enable exchanges in some cases to charge more during this time for trading because of their market position.”
One head of trading at a large active asset manager said: “We are supportive of competitors, as competition tends to drive costs lower.”
The rise in volumes has enticed national exchanges’ rivals to offer competing products. They hope they can cater to fund managers, especially the passive investors that rely on the closing price to track their specific benchmarks.
Tim Cave, an analyst at Tabb Group, the capital markets consultancy, said: “There’s a gold mine out there for whoever gets this right.”
Cboe Global Markets’ European arm is considering creating a product that will compete with the main closing auctions, people with knowledge of the matter said. Aquis Exchange has a product of its own.
There is also competition from banks and brokers, which are taking orders from asset managers during the day and guaranteeing them the closing price. Some brokers have approached high-frequency traders about working together to offer such services, said a person familiar with the matter.
Turquoise, a venue that is majority owned by the London Stock Exchange, is also exploring its options. Robert Barnes, chief executive of the venue, said traders could pair off during the day, with the deal to be struck at the official closing price of the primary market. One order type would lock traders in, whereas the other would permit traders to withdraw until near the start of the closing auction.
But there is trepidation about competing auctions. Several traders at banks and asset managers are cautious about a proliferation of closing prices, fearing a scenario where, for example, Vodafone closes at 130 pence on one exchange but 129 on another.
Ed Wicks, head of trading at Legal & General Investment Management LGEN, -0.33% , which has a very large passive business, said: “I’m cautious about fragmenting closing liquidity.”
“I don’t see a need for competitors to the primary exchanges during the closing auction. The market is fragmented enough already,” agreed Dan Nicholls, head of trading at Hermes Investment Management.
However, some traders say there is ample demand for products that can offer buyers and sellers of a stock the chance to trade at the official closing price for a cheaper rate, and that rival closing auctions might be the only way to keep exchanges’ pricing in check.
The dynamic is intimately familiar: if everybody trades in one place, there is a high chance of matching up, but having just one place to trade comes at the expense of competition.
Neil Bond, head of trading at Ardevora Asset Management, an active equities investor, said: “As volumes polarise towards the close, we are seeing some competition for this business. While this may result in some fragmentation, it also serves to self-regulate against uncompetitive pricing.”
The case for a shorter trading day
The rising popularity of closing auctions has stimulated debate about their advantages, trade-offs and risks. It is also raising more fundamental questions about the working culture of trading.
Some say that narrowing the time frame in which stocks are traded could open the door to a better work-life balance and increased gender diversity in the industry.
The 8am market open in London typically means that traders, though highly paid, must be at their desks as early as 5am or 6am. This is often cited as one of the myriad reasons traders are typically men, as women are disproportionately left with sole or primary responsibility for managing childcare.
The head of trading at a large UK asset manager said: “Given the wider focus on agile working and work-life balance, reduction in trading hours can only help boost employee morale. Trading will simply fit into a smaller window.”
A broker said: “If shortened trading hours were to lead to increased diversity in trading, then all the better.
“But it would probably take more of a mentality change in the industry, rather than just shortening trading hours.”
Although the New York Stock Exchange and Nasdaq open at 9.30am local time, men still dominate the senior trading roles at banks and fund managers, others observed.
Dan Nicholls, head of trading at Hermes Investment Management, said: “Although this would be beneficial from a diversity perspective, I can’t envisage markets being able to accommodate such a change.”
Nicholls pointed out that London’s international appeal as a trading destination is its time zone, which allows the City to trade with Asia in the morning and the US in the afternoon.
“This timing overlap is important, given the global revenue and operational exposure of many of the companies trading on the London Stock Exchange and European markets. If all European trading started at 9am London time, this would be 10am for the European bourses.”
Others saw advantages to a shorter session.
Eleanor Beasley, head of European market structure at Goldman Sachs, said: “We’d be supportive of a review of European trading hours; the trading day is significantly longer than those seen in the US and Asia. Opening the market later would give market participants more time to digest news and results before the open, and concentrate liquidity in the remainder of the trading day.”