Industry optimistic over HKEx closing auction

Buy-side traders and brokers have been re-engaging Hong Kong stock exchange officials over the possibility of reinstating the bourse’s closing auction mechanism.

Industry players are optimistic that Hong Kong Exchanges and Clearing (HKEx), the exchange’s holding company, will propose its resumption in a new round of consultation soon.

The mechanism was introduced in May 2008 only to be pulled in March 2009 during the global financial crisis after it was blamed for increased volatility when HSBC suffered a drop of over 20% in a single day that month.

As it stands, the price calculation system takes the last five prints of a stock at 15-second intervals during the final minute of an afternoon trading session up to the 4pm close. It then takes the median of those prints as the closing price and publishes it after market close.

But this system has been heavily criticised and blamed for causing performance slippage among passive index-fund managers, derivatives traders and ETFs since brokers find it hard to trade at the closing level.

In order to trade as close to the final price as possible, brokers have to keep bursting orders into the system to trade at what they predict will be the five nominal prices the system will adopt.

Gerald Greiner, chief operating officer at HKEx, told AsianInvestor that the exchange also recognises a change is necessary. “It's clear to most of us here that we need to come up with a better way to do a closing auction because we really do need one,” he says.

“[But] we need to cover all the concerns there were with the [previous] one. We're doing internal work and we hope we can get consensus. We have no timetable on this yet.”

Earlier this year it emerged that 100% of respondents from Asia TraderForum, a membership group of heads of Asian equity trading, told a Deutsche Bank survey they support replacing the mechanism. These findings were then presented to HKEx in April, and are under consideration.

The closing auction is purely a window for order entering, and orders only get filled based on one single price at the end of the auction. The exchange’s algo will work out at which price level most orders on the stock will get filled.

This closing auction is often correlated with less volatility, in part due to its ability to stem order imbalances and its transparency that maximises buyers’ and sellers’ desire to trade during the auction window.

The slumping of HSBC’s share price in March 2009 led some participants to suggest the closing auction was open to manipulation – a key reason why the HKEx opted to retract the mechanism in the first place.

However, Deutsche Bank’s global market structure team, led in Hong Kong by Jessica Morrison, recently studied the relationship between the closing auction and trading volatility at close across exchanges in Hong Kong, London, the US and Japan for six months to May this year.

It found that among the Hang Seng Index, FTSE 100, S&P500 and Nikkei 225 benchmarks, volatility on the Hong Kong exchange peaked significantly in the final few minutes. Of the other three with closing auctions, there was no major volatility spike towards the close. 

Citing responses gathered from the survey, Morrison points to measures that exchanges have put in place in London and New York effectively preventing traders from gaming the mechanism or marking the close (moving the price up or down deliberately).

The London Stock Exchange, for example, uses a random start time for the closing auction that varies within 30 seconds so market participants can’t predict when the final price is determined.

“Such randomised start-time arrangement takes away the ability of a trader to put in or cancel an order immediately before the final uncrossing price is determined,” notes Morrison.

The NYSE, meanwhile, allows only closing offset order types to be entered for the last 15 minutes of auction. What this means is that if there is heavy interest on the sell-side of the order book to indicate that the final price will be pushed lower, the last orders on the day can only help to correct such imbalance, she adds.

Respondents to the Deutsche Bank survey, who manage over $500 billion in assets, were some of the largest global asset managers operating multiple strategies, comprising long-only, long/short hedge funds.

Deutsche believes this client base makes up the vast majority of closing volumes as they trade their portfolios to benchmarks.