Markets in the U.S. and Canada have a pretty unique way of closing.
In most other countries, there is a separate market close auction after continuous trading ends. In contrast, North American markets build the auction book while continuous trading is still occurring.
There are good reasons to do this, but some complain that this creates information leakage. Today’s research shows that the imbalance information does in fact have a material effect on price – but that seems to reduce the volatility into the actual MOC price. We also find that because imbalance information is shared with all professional traders at the same time, they efficiently re-price the stock within 300ms, leading to relatively small costs for the liquidity in the close, and small profits for those offsetting the imbalance.
The U.S. process helps reduce overnight risk
European markets close while U.S markets are open, making it easy for a liquidity provider to hedge a position caused by large imbalances. In contrast, when U.S. markets close at 4.p.m, there are no other markets open, and no way for arbitrageurs to hedge U.S. futures (which close at 4.15 p.m.). It’s not until much later that relatively smaller markets in Auckland, Sydney and then Tokyo open.
Consequently, a European-style close in the U.S. market would require liquidity providers to carry more overnight risk. That in turn would likely increase the cost of liquidity in the close and reduce the returns of index funds and investors managing cash flows.
Instead, the U.S. style close allows professional traders to facilitate MOC imbalances using liquidity from the last few minutes of continuous trading, by accumulating liquidity just before 4 p.m. to help offset close imbalances.
Competition for MOC flow is efficient at offsetting liquidity risk
Today’s analysis also shows two important things (Chart 1):
- The imbalance announcement carries meaningful information. We see prices move, and in a predictable direction, on the publication of the imbalance news. Because of that, it’s important to investors that the liquidity cost is priced as competitively as possible.
- The market reacts almost instantly and efficiently (from a price discovery perspective) to the news, rising (or falling) almost instantly on the news of a buy (or sell) imbalance, by roughly the correct amount to price the official close.
Chart 1: The information content in the MOC imbalance is priced into the market by participants almost instantly and efficiently
Source: Nasdaq Economic Research
We analyzed all the imbalances for Nasdaq 100 companies during Q2-2019.
We see that when a buy (or sell) imbalance is announced the stock gapped up (or down) by roughly the right amount. In fact we see that about 80% of the ultimate price move into the close was priced in within 300ms (see grey box in chart 1).
The fact that markets move so quickly means as almost all trades after the imbalance news also end up paying a “fair” price for the stock given the risk that they warehouse for the minutes into the close—meaning the profits from liquidity provision are minimized.
We also looked at larger and smaller imbalances. The data in Chart 2 shows that for larger imbalance trade size, the market moves more than for smaller imbalance trade sizes. That’s consistent with impact cost research, which shows that larger imbalances have more market impact (Chart 2). It’s also consistent with the economics of supply and demand. Demand more, and prices rise more.
Importantly, the price reactions for larger and smaller trades (line thickness) were also very consistently close to the final close price. Those results indicate that professional liquidity providers are involved, and are very efficient at knowing the right price for the liquidity required.
Chart 2: Larger imbalances have more information, but the market is still instantly efficient
Source: Nasdaq Economic Research
Why is this important?
This proves a number of well-known facts about the way the U.S. market works.
First, the MOC flows has information for traders. That’s why it’s important that all professional traders can see it at the same time to keep the market fair.
Secondly, the market is pretty efficient. Although there is information in the imbalance announcement, it is priced into the underlying prices almost instantly. Then, the liquidity in the last five minutes is able to be compiled by liquidity providers to offset the close.
In fact, the last 10 minutes of the day is pretty stable compared to the average volatility during the day. Our analysis shows that the close prices move an average of 5.5bps immediately after the information in the NOII announcement. That’s a fraction of the average 272bps range during the whole day, and just over 1-times the average spread (Chart 3). More importantly, the liquidity premium, or profit earned by those facilitating the close imbalance news, is just 1.7bps on average, or less than half the spread.
Chart 3: Comparing the price reaction to the close imbalance news to spreads and intraday volatility
Source: Nasdaq Economic Research
In short, it appears that profits from facilitating MOC liquidity are, on average, small and in proportion with the risk being taken and the sophistication to price and hold this risk.
The impact of imbalance information on stock prices shows why we think proposals like the Cboe market close are bad for the market. Imbalance information is clearly important for price discovery. That makes having a single auction without separate information leakage to specific traders really important to index funds and investors. If imbalance information was leaked to specific participants ahead of the close, it’s possible that any fee savings would be more than offset by market impact, making the investors trading in the close worse off in total.
What we have now, a single MOC auction with an NOII released to all professionals at the same time, and time to pull liquidity from continuous markets into the close, creates a competitive dynamic and a level playing field that the data suggests works well for investors and gives index funds low-cost liquidity.
Bonus Section: How exactly does the U.S. MOC auction work?
Primary listing exchanges manage the most important closing auctions. That’s because the primary exchange is chosen by index providers as the official price for their indexes, which in turn are used for portfolio measurement and risk management. It’s one way traders help share the costs of attracting and servicing issuers, something that benefits all investors.
In the U.S., the most corporates are listed on Nasdaq, followed by NYSE. The table below shows how these two exchanges have slightly different way of managing the close.