Crowded Closing Auctions

The closing auctions at equity exchanges are attracting a larger fraction of the daily volumes, and today in Europe, the Middle East and Africa about for 25% of daily volumes were traded during the closing auction during Q1 of 2019, versus 19% during Q1 of 2018 (Marketwatch: as per Goldman Sachs’s quantitative execution services division).

The table below from the AMF study shows a graph of the increase in the share of equity trade volumes during closing auction, across Europe.

The reaction from various market participants have been varied

Investors

• :-) The concentration of trades during closing auction enables the investors to find a deep pool of liquidity
• :-( Not keen on trading during the earlier part of the day due to the fear of missing out on a better price during closing auction

Regulators

• :-( Fear that the skewed distribution of trade volumes, could have an adverse effect on the price discovery function of the markets
• :-( Concerned that the concentration of trades towards closing auction potentially can provide opportunity for market manipulation

Exchanges

• :-) Can charge a premium for trades that are to be executed during the closing Auction period, improving their revenues

Brokers

• :-) Provides an opportunity for brokers and sell-side firms to offer differentiated products due to the difference in liquidity across time
• :-( The reduced liquidity during the earlier part of the day holds the brokerages back from trading, since it may not help their best execution objectives
• :-( Charged more by exchanges to participate in the closing auction than at other times during the trading session

Now, there seems to be two major reason for this to happen

• With the unprecedented and continued increase in passive management, there has been an increase in transactions that aim to trade at the closing price of the day at exchanges. ETF sector in Europe could hit €2tn of assets by 2024, from €760bn in March this year. (Morningstar)
• The MiFID2 regulation caused a proliferation of equity execution venues, especially in Europe, making it difficult for the buy side to find natural liquidity, and hence the focus on closing auction (https://www.thetradenews.com/thought-leadership/venue-landscape-shifts-europe/)

Now, the crowding of liquidity towards closing auction could accelerate and the market might end up with a disparity in liquidity distribution across the trading session. Reducing the trading hours of the markets in Europe may not help in addressing this issue. If this trend continues, I can anticipate an SEC-like round table in the horizon, to talk about the potential cause, impact and resolution on this issue.

Edit: Just wanted to add this recent paper by Vincent Bogousslavsky and Dmitriy Muravyev, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3485840 that says there is evidence that “The closing price is distorted by the huge trading volume executed in the auction,” Past research found auctions improve market efficiency and liquidity, but “there is no price discovery at all at the auction because there is complete reversal” by the next day.

This is a comment of significant importance, given the impact closing prices have on the valuation of ETFs, and other funds in the market.