Curatia Analysis for Wed, Nov 3, 2021

Auctions’ Automated Market Structure Delivers Best Execution Outcomes  Sponsored

Edward Coughlin Director of Trading Services, Nasdaq

Nasdaq launched the world’s first electronic market in 1971, and over the decades it has become the benchmark for exchanges worldwide. Since then, advancements in technology have completely transformed the capital markets, delivering greater operational efficiency and lower costs while providing exciting new products and a better experience for our clients.

Current market structure is designed to take advantage of technology, and we’re particularly proud of our automated auction processes. Nasdaq auctions are used to establish the opening, closing and IPO pricing for all types of securities including ETFs. In fact, Nasdaq’s auction process has been copied in markets throughout the world.

While markets have gotten faster and more efficient, we believe offering superior, high-touch, human support is a value add to our clients and issuers. Nasdaq’s service model and ETF issuer support programs go above and beyond – from our innovative liquidity-provider incentives to our team of subject-matter experts for all things ETF.

Efficient, Transparent, Flexible Auction Process

Nasdaq wants to do everything possible to create the best execution outcomes for investors. Beginning in 2018, we added auction imbalance information and changed the cutoff times in the closing cross to increase transparency and flexibility. Market-on-close orders may be entered until 3:55 pm ET, and limit-on-close orders may be entered until 3:58 pm ET.

We continue to accept imbalance-only orders until the closing auction occurs with no cutoff periods. The additional time and information allows firms to make more informed decisions on how and when to participate. The industry has now embraced, and has confidence in, these processes.

Importantly, these changes delivered even greater efficiency. To illustrate, in last December’s Airbnb IPO, which was well received by market participants, nearly 7M shares with a notional value of $1B were traded in the IPO auction.

Barely a week later, the S&P 500 rebalance took place at the close – which was also the quadruple witching hour, when stock index futures, stock index options, stock options and single stock futures expire simultaneously. About 1.7B shares with a notional value of $150B were traded at the closing auction. Notably, 69M shares of Tesla with a notional value of $50B were traded in the closing cross– five times the previous largest trade.

In 2021, we similarly refined the opening-cross process to deliver more information earlier and allow additional time to enter orders for participation in the opening cross.

Previously, we started publishing imbalance information at 9:28 am ET. Now we’re publishing imbalance information at 9:25 am ET and allowing entry of limit-on-open orders until 9:29:30 am ET to give participants an early look at the opening auction. Firms can get a sense of what trading will be like during the day and determine participation in the opening more flexibly.

With those changes, liquidity providers can be more interactive in the opening and better understand products’ fair value. The changes have been especially important to ETF issuers, designated liquidity providers (DLPs) and liquidity providers. They’re more likely to recognize and react to mispricings due to temporary supply and demand imbalances by entering stabilizing orders to ensure orderly auctions.

Further, the change has attracted additional liquidity providers and improved execution outcomes in the auctions. Nasdaq has an ongoing commitment to ensure our auctions provide the best possible price discovery process.

High Performance, Even in Stressed Markets

Market participants often think opening and closing auctions require human intervention. However, the data doesn’t support that perception, even when markets are volatile and trading volumes high. In March 2020, markets were consistently stressed due to uncertainty surrounding the COVID-19 pandemic. Nasdaq wanted to assess how effective the opening auction price is by looking at how much prices change in the five minutes after the stock has opened.

Focusing on S&P 500 companies, we compared the five-minute volume-weighted average price for each stock to the open auction price. The difference between the two is called the auction price dislocation. Then we computed a trade-weighted average, based on daily opening/closing auction dollar volume, for each ticker across the dates. Trade weighting ensures that the "costs" calculated are closer to what investors experience, as they do more trading among the more liquid stocks. The research showed that compared to other exchanges, automated opening auctions resulted in relatively better price discovery and less price volatility throughout March 2020 – the most volatile month in 33 years.

We also looked at how much prices change in the five minutes before the stock closes. Again, using trade-weighted S&P 500 companies to ensure a reasonably comparable set of stocks, the data show that Nasdaq stocks had slightly less volatility into the close versus other exchanges.

Spreads near the open tend to be wider than around the close. In the morning, there is less confidence on the fair price of the stock, but after a whole day of trading, price discovery is mostly complete. Looking at trade-weighted spreads in S&P 500 stocks during March 2020, Nasdaq spreads were relatively tight in the morning, the afternoon and throughout the day.

Above and Beyond Support

We’re grateful for issuers that put their faith and trust in Nasdaq to launch their products on our exchange, and we recognize that demands on liquidity are growing constantly. As such, we devote significant resources to ensuring our automated auction process is both resilient and flexible for liquidity providers and investors as well as indexers.

ETFs typically don’t attract a significant amount of trading volume on day one, because it takes time to build investor awareness and a performance track record. To that end, we offer the best service model and issuer support programs possible. For instance, we’ve recently rolled out changes to our DLP Program designed to improve market quality by aligning the program incentives to best fit varying levels of ETF trading volumes.

Finally, our support team is a valuable resource to ETF issuers as they navigate regulatory and market-structure changes. Our team members are subject-matter experts for all things ETF. They field all incoming queries, ranging from questions about why or how a trade occurred to how new rules and regulations affect our clients. The team can also recommend best practices for educating clients. We pride ourselves in going above and beyond to service our clients, and we’ll continue to answer all inquiries in a thorough, accurate and timely manner.

About the Author

Ed Coughlin currently serves as the Director of Trading Services and has over 30 years of experience in the securities industry and securities-related matters. He currently oversees the Nasdaq trading desk where he is responsible for the operational day to day activities. In addition, Mr. Coughlin represents Nasdaq on the industry’s LULD committee and is involved with market structure initiatives to improve auctions and reduce the risks associated with automated trading.

Prior to joining Nasdaq, Mr. Coughlin was employed by Surge Trading where he served as the Head of Trading and Operations. In his role at Surge, Mr. Coughlin was responsible for supervising all market making and proprietary trading activity in addition to overseeing the day to day operational functions.