Hong Kong Exchanges & Clearing Ltd. should reinstate a closing auction for equities to help calm price swings at the end of the day, according to investors polled by Deutsche Bank AG.
The Hong Kong bourse operator suspended the procedure in March 2009 after moves in stocks spurred concern they were being manipulated. Deutsche Bank’s institutional clients unanimously asked for an improved system for automatically matching trades at the end of the day, the survey found. Local independent brokers oppose closing auctions, said Francis Lun, chairman of the Hong Kong Institute of Financial Analysts.
Exchanges in most countries use auctions as a way to establish closing prices by pooling share orders and finding the level at which the most can be matched. The process, shunned by only Hong Kong and Shanghai among the 10 biggest markets worldwide, may reduce volatility and limit manipulation, according to a 2006 paper tracking the introduction of the process at Singapore’s stock exchange.
“The implementation of a proper closing auction will create a fair mechanism where price discovery, based on supply and demand, would establish an orderly closing price,” Joseph Sarcona, head of electronic trading in Asia at Morgan Stanley, said in an interview. “Such a mechanism would be to the benefit of the entire investing community.”
Hong Kong uses the median price from the final five transactions in a stock to calculate its closing level. While the system is not immune to manipulation, it is more democratic, said the Institute of Financial Analysts’ Lun.
“There is no way to prevent manipulation,” said Lun, managing director of Lyncean Holdings Ltd., a local brokerage, in a telephone interview. “The key is how do you make it as equitable and fair as possible?”
Closing auctions, by bundling all trades into one pool, mean that more capital needs to be deployed to sway prices, researchers led by the Australian National University’s Carole Comerton-Forde concluded after a study of Singapore Exchange Ltd. While the researchers said that reduces opportunities for manipulation, Lun says it means that only large players will be able to influence prices.
“HKEx is aware that there are diverse views and trading needs regarding the closing prices,” Scott Sapp, an exchange spokesman, said via e-mail. “HKEx will continue to work with its stakeholders on the market closing mechanism.”
Deutsche Bank surveyed its institutional clients and the Asia TraderForum, whose members have more than $500 billion under management, about the closing auction and gave the results to Hong Kong Exchanges & Clearing the week of April 2. Its shares fell 0.2 percent to HK$128.60 at the midday break today.
The local bourse canceled its closing auction three days after HSBC Holdings Plc, at the time the second-biggest stock listed on the benchmark Hang Seng Index, fell 10 percent after the close on March 9, 2009. The drop extended the decline on the day to 24 percent, the stock’s biggest retreat in at least 23 years, and prompted complaints from market participants, legislators and the city’s Financial Secretary John Tsang.
The plunge was the result of “technical trades,” Sandy Flockhart, chief executive officer of HSBC’s Asian business, told reporters in Hong Kong March 10, 2009. The Securities and Futures Commission began a formal investigation the next day into whether the closing auction was manipulated.
The results of that probe are still unknown. “We do not comment on the progress of investigations,” SFC spokesman Ernest Kong said when asked if the matter was still open.
The procedure was suspended “due to HKEx’s concerns about any appearance of abuse during the closing auction session and the need to maintain public confidence in the orderliness, fairness and transparency of the market in light of recent price volatility during the closing auction session,” the exchange said in a statement on March 12, 2009.
Possible mechanisms to limit manipulation in future auctions include randomizing the exact closing time so a firm can’t put in a market-moving order just before close, and preventing orders from being cancelled for a set period before the close.
“We understand people’s concerns because of what happened with HSBC, and this is why we support a randomized closing time to prevent manipulation,” said Alastair Hills, a spokesman for TraderForum. “We believe a closing auction will benefit all market participants.”
Closing prices in Hong Kong are currently determined by the bourse recording five prices, 15 seconds apart, before the close. After those trades have been completed, the median price becomes the official close. Brokers have no certainty whether the final price they traded at will be the closing price.
The ability to match the closing prices of portfolio stocks is critical for funds that track benchmark indexes. A less predictable process increases costs by forcing brokers to charge more for the risk they assume in guaranteeing funds get the right price.
“For these funds it’s critical that they can achieve the closing price,” Jessica Morrison, head of market structure at Deutche Bank said in a phone interview. “These are the people managing Mom and Dad’s pension funds, so they are going to be trading in size and must be able to demonstrate that they have traded in line with their mandate.”
With a closing auction, everyone puts in their bids and offers during a pre-defined period. The exchange uses an algorithm based on volume and price to find the level where most trades can be completed. Investors who entered a market order within those last 10 minutes know they will get the official closing price while those entering a limit order will trade if the closing price is within their limit.
The Australian National University’s Comerton-Forde co-authored a study in 2006 on the introduction of a closing auction to Singapore Exchange in 2000. The process spurred a decline in market swings and a reduction in bid-ask spreads at the close, which reduced the opportunities for manipulation, according to the paper.
“Given the closing price is an official price used for many valuations and benchmarks, there needs to be effective controls in place to prevent the price being moved deliberately,” according to the Deutsche survey.