Five Critical Minutes
The closing mechanism is increasingly important to Europe's stock markets
Source: Rosenblatt Securities
It’s all thanks to the boom in exchange-traded funds, which mostly trade at the close to track final prices. Their growth has ignited a self-fulfilling cycle that’s drawn even more traders to closing auctions.
In most of the trading day, shares change hands across multiple venues, from exchanges to dark pools. But at the close, auctions organized by the primary bourses alone complete the last trades and set a final price.
That effective monopoly has stirred anxiety over the potential havoc in case of a breakdown as well as exchanges’ growing clout to raise trading fees. But more simply, in Europe, the importance of closing auctions has thinned liquidity during the day, prompting traders to ask: do we need such long hours?
“You could cut two hours off the trading day,” said Ross Hallam, head of equity trading at RBC Global Asset Management in London. “It would make no difference.”
That might feel especially true this year. European equity trading volumes are down 13% in the first five months of the year from the same period of 2018, Rosenblatt data show, amid geopolitical and economic uncertainty. More than a year of relentless outflows from the region’s stocks probably also haven’t helped.
There’s a reason why European trading starts as early as 8 a.m. in London and closes at 4:30 p.m. One of the region’s advantages has always been that it’s uniquely situated to span both the Asian close and the Wall Street open. Asked about shortening the hours, the Federation of European Securities Exchanges, a body that counts Euronext NV and Nasdaq’s bourses among its members, pointed to the need to serve end investors and to interact with other markets.
But popular as they are, closing auctions’ greatest strength is also what worries traders. As a centralized system, they offer more certainty than the continuous trading session.
But this poses its own problems. First, any breakdown could destabilize markets. Second, that may embolden exchanges with a monopoly over closing auctions to raise fees. This could squeeze brokers already saddled with declining trading, and ultimately, asset managers.
Just Wait For It
LSE has seen volumes increasingly migrate to its closing auctions
Source: London Stock Exchange
Another worry is that closing prices will increasingly diverge from prices in the continuous trading session, making it harder for traders to place orders in the final auctions.
“We, including myself, must go with the herd,” said Guillermo Hernandez Sampere, head of trading at German asset manager MPPM EK. “It might create a problem because the liquidity will shrink during the day, which will affect volatility and it will make more traders superfluous.”
To be clear, this doesn’t necessarily mean investors are hankering for alternatives that might fragment the current system.
“There are benefits to competition and we’ve seen what that has done to continuous trading,” said Ed Wicks, London-based head of trading at Legal & General Investment Management, which has a large passive business. “But we definitely don’t see a need for competing price-forming auctions and a single closing price is preferable.”
The fact that closing auctions make up a larger percentage of volumes in Europe than in America might come as a surprise, given that passive products account for about 15% of investment assets in the former, far lower than the 37% across the Atlantic, according to Moody’s Investors Services.
That may be partly because in the U.S., the closing auction coincides with the end of continuous trading, offering other venues to trade around the final price, whereas in Europe, it takes place afterwards, said Tim Cave, an analyst at Tabb Group, a research firm specializing in capital markets.
“The actual closing auction mechanisms are well-established and widely understood,” Cave said by email. “The longer trading day in Europe compared to the U.S. also naturally forces more trading to the close because of thin liquidity in the morning and early afternoon trading sessions.”
By limiting brokers’ ability to match clients’ orders outside of organized venues, European Union financial rules known as MiFID II, which took effect in early 2018, may also have accelerated the shift toward closing auctions, Cave added. Hallam’s team at RBC is increasingly taking advantage of them, especially on index re-balancing days, to make large trades.
The average trade size in closing auctions for FTSE 100 shares was 39,000 pounds ($49,772) last month, compared with about 4,000 pounds in continuous trading, London Stock Exchange data show.
So can Europe shorten its trading day? RBC’s Hallam said he’s heard the suggestion discussed at conferences, but there’s nothing close to a substantive push.
“Do we need 8 1/2 hours of continuous trading session?” said Legal & General’s Wicks. “It’s definitely a fair question to ask.”