Northern Trust On Futures Closing Auctions

By Northern Trust’s EMEA Head of Dealing Martin Ekers.
Like a lot of passive index managers we use index futures to augment portfolio investment to avoid cash drag on portfolios etc. So when you’ve got an element of cash in any passive portfolio, you would typically have that invested in futures. Historically, there have not been opening and closing auctions, as we know them in equities, and I think it’s mainly an anomaly that’s never really come to the fore. There is a lot of activity around the open and the close in all the major equity index futures markets which would, I believe, be significantly helped by an official opening and closing auction algorithm that allowed people to enter orders, either at market or with limits and then everyone would be treated equitably and fairly. The answer to who might drive that to happen is the exchanges where these products are listed, all the well-known big venues. The issue is that the ownership of those entities varies significantly.
But the incentive for them to introduce this process is not great. The pressure for them to not vary comes from the makeup of those exchanges, because if you’re an exchange that’s predominantly owned by locals trading on their own behalf they’re very keen not to see closing auctions come in because it’s a very important source of revenue for the day traders who put bids and offers in the marketplace and try to capture the spread.
These are exchange listed and traded equity index futures. They’re not OTC derivatives. These are pretty vanilla instruments. If I have the same contract out with different brokers for the same benchmark, I frequently get different prices and that’s just the nature of the market and, although it can be a matter of a few seconds, obviously, between one order hitting the system and the other one hitting the system you just get a different result.
I think other buy-side firms have, to some extent, started to try and grapple with the problem about first of all, which benchmark point we should be targeting. Continuous trading in the UK for example, stops at 4:30 and then the auction is 4:30 to 4:35. Now, the official close, as far as the index providers are concerned, is 4:35. And yet, if you ask 50 people in the street, probably 30 would say the market shuts at half-past four, but actually it doesn’t. So, I’ve asked my futures executing brokers what the standard is and some of my peers target 4:30 and some target 4:35. The liquidity in the futures market is slightly better I think at 4:30 than 4:35. But our view was that we wouldn’t be targeting 4:30 and having five minutes of risk because our benchmark is 4:35.
And on the developed European markets now, maybe 20 percent or so of the whole day’s volume is done within the closing auction in equities and yet that is probably the highest risk point for an index arbitrager because the index future can move so quickly either side of that very definitive point after the closing auction price has been decided, determined and distributed. So if you think most markets, whether it is the UK market, German market, French market, etc., have a five-minute period of orders building into the system for the closing auction calculations to be made. And then, in an instant, those prices are distributed and people know what they’ve sold at and what price they’ve bought at. And if you’re an index arbitrager and, as that happens, the index future suddenly moves, or all the equities moved because of somebody putting a big order in just before the close of the auction, then your calculations can be very seriously adrift. So maybe if there was a futures closing auction coinciding with the equity closing auction, it would be a very simple case of calculating the mass and putting your orders in contingent one against the other.