With the increased concentration of trading activity at the close, what is the potential fall out?
There has been a clear trend over the past 5+ years that the proportion of average daily turnover executed at the close has increased and various contributing factors have been suggested as drivers of that. This includes the mooted rise of passive investment strategies, the continued importance of the closing price as a desirable benchmark, the evolution of alternative market mechanisms that drain liquidity out of lit-continuous trading phases and the effect of algorithmic trading strategies reacting to a redistribution of liquidity towards the close – in other words, liquidity begets liquidity.
So what is the fallout of this? Some argue that there is increased risk when a larger proportion of daily liquidity is concentrated in a single liquidity event, but whilst the impact may be higher it doesn’t necessarily mean that likelihood of a disruption to such a liquidity event is greater compared to likelihood of disruption to intraday trading sessions. However, it potentially influences the dynamics of price formation and the capacity for immediate risk transfer throughout the course of the trading day.
The continuous trading phase on central limit order books (CLOBs) is a critical source of price formation and liquidity certainty. Their prices are referenced directly across many alternative trading mechanisms and also indirectly in closing auctions, which typically have volatility interruptions based on percentage deviations from the last traded price in continuous trading. Hence, it is important that an unfettered shift in liquidity dynamics does not undermine essential market mechanisms like the continuous trading phase on CLOBs.
Are exchanges making any moves to address this increased concentration?
Across the street, a lot is evolving in the space. One of the things we’re seeing are additional mechanisms which have come to market, that facilitate continuous intraday crossing opportunities. Some of these, like periodic auction models are not new, whereas more recent evolutions – such as bilateral price streaming, segregated retail liquidity models, and trajectory crossing models – are focused on matching of specific types of flow with appropriate contra liquidity. Such mechanisms provide alternative ways for participants to access intraday liquidity on a continuous or semi-continuous basis, but also potentially drain displayed liquidity away from lit-continuous trading sessions on CLOBs.
Additionally, venues incentivising broker-preferencing in non-continuous trading sessions may further encourage additional liquidity into auction phases, increasing the proportion of daily liquidity traded at the close.
We’ve also seen an evolution of how people trade in closing auctions. With the size and variability of the average closing auction imbalance reducing significantly across European orderbooks over the past 5+ years. This will be driven in part by growth in internalisation around the close, but also in part by auction strategies that constrain auction participation based on the theoretical closing volume in order to reduce price impact.
The fairly ubiquitous use of participation caps in closing auctions is why for example SIX innovated to introduce the Auction Volume Discovery (AVD) order type, which essentially is a non-displayed auction order type that has no impact on theoretical closing volume or price. It provides a suitable mechanism to encourage volume constrained liquidity back into the closing auction in order to maximise matching opportunities. Since launch, we see evidence of such volume constrained liquidity coming back into the closing auction via AVD and changing the auction imbalance picture. This likely underscores the benefits of centralising rather than fragmenting liquidity around such an important daily liquidity event.
How can – or is – the industry balancing liquidity needs with market stability?
Periods of significant volatility are of course difficult to predict, and though we don’t necessarily live in a highly volatile market environment every day – we still have some significant blips. When these occur you typically see increases in volume traded as investors are trying to adjust their positions to respond to rapidly evolving market conditions.
In such periods, the opportunity cost of not trading outweighs the opportunity cost of trading sub-optimally from an execution performance standpoint. Certainty of liquidity becomes a priority, which is why we often see evidence of a flight toward lit order books where liquidity and price is clear and transparent. In periods of low volatility and low volumes, managing for price impact in thinner orderbooks can prompt market participants to explore alternative execution mechanisms. It is a fine balance, between ensuring that price and liquidity certainty is not unduly diluted in optimising for execution performance. This probably necessitates that appropriate regulatory frameworks are in place to help preserve important market mechanisms, but conversely it can’t be regulation that stifles innovation and the ability for end investors to execute in a way that benefits them.
SIX has long been a staunch advocate of competition, innovation and offering a selection of market mechanisms – but we also advocate that price formation, transparency and equality of access are critical for the market. It is a tough balance for the market as a whole to get right.
Looking at the rest of 2024, what is the biggest challenge facing traders?
In general, I think market participants are really cognisant of the challenges of what appears to be a relative drought in liquidity in Europe relative to other markets. There has been recent conjecture as to whether the addressable liquidity picture in Europe is being distorted and understated due to how certain off-book / OTC trading activity is being reported – in particular, bilateral price-streaming mechanisms and specific swap trading scenarios. Such topics will probably be a re-invigorate of some of the well-trodden debates we have seen in the past around appropriate market structure, regulation and reporting regimes. The recent release of the next ESMA consultation will provide a focal point around which such debates will play out – with a focus on reducing complexity and increasing efficiency within the equity trading ecosystem.
This is of course important, however we’re also facing a changing political landscape at present (being a super election year) and that perhaps presents us with a collective opportunity as an industry to address some of the other elephants in the room that act to restrain equity trading volumes. Such examples include the taxation of equity trading, accounting principles and/or prudential requirements that significantly restrict pension and insurance funds from holding equities, and the overreliance on bank loans as the primary source of growth capital for SMEs in Europe.
In advocating for a rethink on such topics we need to ensure policy makers and the wider public understand the benefits of thriving equity markets. They help to drive the real economy, are a wealth creation tool for retail investors, and stimulate resilience to and recovery from economic shocks. It is vital that such topics are given as much consideration as those aimed at reducing market complexity.