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Curatia Analysis for Wed, Jul 10

In Auctions, Equities Markets Find Both Savior and Siren

Auctions’ burgeoning popularity on equities exchanges reflects industry trends including the rise of passive investing, an uptick in buy-side clout, and the increasingly global scope of market structure innovation.

But some market participants are warning auctions can also thin liquidity, raise trading costs, and heighten systemic risks as trading becomes highly concentrated in time as well as place.

Popularity

Amid a slew of high-profile clashes over market structure in recent years, the somnolent subject of auctions stands out only for its ability to blend in. Still, it has arguably proven no less transformative for equities trading than market data fees or MiFID II.

Closing auctions now make up 20% of trading volumes in Europe, up from 12% just three years ago. In the US, where the timing of closing auctions lets other venues trade around a stock’s final price, closing auctions constitute 8% of equities exchange volume. But 23% of equities trading happens in the day’s last half hour — a 5% jump from 2010.

Periodic auctions, which saw rapid growth following MiFID II’s January 2018 implementation, meanwhile account for an additional 2.2% of European equities market share.

Auctions owe their rising popularity in part to the explosion of interest in benchmark-tracking funds, which rebalance based on securities’ end-of-day prices. Passive-investing products have grown to account for 37% of assets in the US.

That figure has bolstered the clout of buy-side firms seeking to trade large blocks of stocks without prices moving against them. In May, the average trade size in closing auctions for FTSE 100 shares was roughly ten times the average trade size in continuous trading.

Proliferation

Those dynamics have driven demand for auctions around the globe. Hong Kong Exchanges & Clearing, for example, will expand its closing auction session from 700 securities to more than 2,600 beginning October 8.

Waxing buy-side influence has also piqued interest in other liquidity aggregation techniques. Nasdaq Copenhagen introduced a 10-minute “trade-at-close” session in May to allow market participants to execute trades at the closing auction price once the closing auction is complete. Singapore Exchange followed suit barely a month later.

Buy-side traders have likewise embraced conditional orders, in which trading venues notify trading parties before executing a matched order to reaffirm their desire to trade, as a means of aggregating liquidity across multiple venues.

In Europe, traders have hailed the rise of periodic auctions as a silver lining in otherwise ineffectual MiFID II legislation. Exchange operators “breathed a sigh of relief” after ESMA’s “hotly anticipated” report on periodic auctions avoided mention of any outright ban or hard caps on the practice.

Pitfalls

That doesn’t mean auctions are free of perils.

Critics have voiced concerns over thinning liquidity during the trading day. RBC Global Asset Management head of equity trading Ross Hallam recently suggested “‘you could cut two hours off the trading day [and] it would make no difference.’”

At 8.5 hours, Europe’s trading day is the world’s longest. A 13% drop in YoY equity trading volumes in the first five months of the year has served to highlight liquidity issues.

“Reduced confidence in intraday prices” is another danger inherent in closing auctions’ redistribution of trading.

In addition, some market participants have argued closing auctions could undermine competitive dynamics by giving listing exchanges a “natural monopoly” on a growing proportion of trades. Many exchanges charge higher fees during auction periods, raising the specter of another controversy over exchange fees.

Critics have also worried that closing auctions render primary exchanges single points of failure, creating systemic risk.

Despite such concerns, auctions and other liquidity aggregation solutions continue to gain traction in stock markets. Whether they can maintain that trajectory may depend on passive investors’ resolve to stay the course in a market downturn.