At swimming competitions, the 100-meter freestyle is one of the most difficult races. Given the compressed distance, the most critical moments are at the beginning and the end. For a swimmer to succeed, they must “get off the blocks” at exactly the right moment and reach the finish in a perfect full extension to edge out the competition. Trading days at listed stock exchanges are similar to 100-meter races in that the beginnings and ends are the most critical moments.
Listed equities begin and end trading with opening and closing auctions—also known as “crosses.” These concentrate liquidity, bringing together buyers and sellers for the initial and final trades of the market day. They provide a very efficient price discovery mechanism that makes it easier to execute larger block-sized orders without significant market impact on price.
The auctions have always been an essential function of the market by providing liquidity events and setting essential benchmark prices for trillions of dollars in assets. However, the stunning growth in the popularity of exchange-traded funds (ETFs) and other passive investments have made the way these crosses function even more important to a larger universe of market professionals and investors because these investments rely heavily on the official closing prices of the stocks in their benchmark indexes—and it is the closing auctions that set these prices. Indeed, global institutional assets under management (AUM) for passive strategies grew to 22 percent of total AUM in 2015, from just 14 percent in 2008, according to Greenwich Associates’ Trading the Auctions report. Meanwhile, closing auction volume has increased substantially, from 3.6 percent of total daily volume in 2011to 5.5 percent today, according to the report.
Importantly, it’s not just the passive strategies that are impacting volume at the crosses. Passive investment participation attracts additional liquidity, increasing momentum and creating a stronger liquidity growth cycle. Traders using strategies that interact with the order flow from this passive money also play a role. For example, the use of guaranteed “market-on-open” or “market-on-close” strategies increased from 5 percent of portfolio trading in 2015 to 14 percent last year, according to Greenwich Associates.
The growth in these types of trades suggests that to work most effectively with the opening and closing auctions, market participants must truly understand how exchanges build liquidity during the crosses, as well as understanding the data available to them—specifically the exchanges’ auction feeds. The Greenwich Associates study found that the auction information may be under-utilized, which could be detrimental to traders looking to participate efficiently in these liquidity events. Traders either do not have adequate access to the auction feeds or are not using them optimally, regardless of the provider. “Knowing supply and demand in real time improves efficiency,” said one agency broker-dealer surveyed by the study.
Just as swimmers in a 100-meter freestyle need to understand how to strategically begin and end the race, traders must understand how each exchange operates its crosses, at the start and at the finish—the times when liquidity is most concentrated, and buyers and sellers are most active.
To begin, while individual equities today trade on a variety of exchanges, only the primary listing exchange is used to set a stock’s official opening and closing prices—the official closing prices that form the input to the index calculations used by ETFs and other passive strategies. Overall, the crosses are an innovative, flexible solution tailored to fit many aspects of how markets operate.
All exchanges follow the same general approach to the opening and closing auctions. Each defines a cutoff time—either in the morning for opening crosses, or late afternoon for the market close—before which all orders to be executed during the auction must be submitted. This creates a period when liquidity for the auction can build. Once the cutoff time is reached, these orders may not be canceled, and—with the exception of imbalance orders, where new orders can be submitted to offset an imbalance between buy and sell orders after the cutoff time—new orders cannot be entered. At this point, data about the state of the auction is published on the exchanges’ auction feeds.
The importance of robust and timely auction data should be obvious. To effectively use imbalance orders, traders must have access to real-time data about these imbalances. The auction data feeds typically provide: (1) indicative price, where the price would be set if the auction were held immediately; (2) paired shares, or the number of shares that could be matched at the indicative price; and (3) imbalance, which is calculated by subtracting sell orders from buy orders.
Since the imbalance data was a new data point in 2003 when Nasdaq launched its crosses, we worked extensively with brokers, data vendors and front-end providers to ensure that this information was broadly available in a usable format for all investors. Markets need transparency for efficient price discovery and to provide a certain level of comfort to the broader trading community. Our Nasdaq TotalView auction feed provides transparent information about liquidity concentrations and opportunities at the open and close, essentially identifying the ultimate auction cross volume within 95 percent accuracy compared to other exchange-operated products.
Today, nearly 7 percent of daily trading volume takes place during the crosses. This sheer size of volume makes it critical for traders and investors to truly understand how to leverage this beneficial feature of market structure to discover more effective prices and trading opportunities.
Just as each exchange auction operates in a slightly different manner, the type of information provided by the auctions also varies from exchange to exchange. Market participants should ensure that they understand these differences to tailor their trading strategies accordingly.
Indeed, 70 percent of respondents in the Greenwich Associates survey said access to real-time auction imbalance data influenced how their firms traded. That level of demand for auction analytics tells us the level of importance this kind of trading is today and will be for the foreseeable future. Just as competitive swimmers know to focus on their strong start and finish, traders are honing their ability to better understand their strengths in order to better trade the opening and closing auctions.
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