Does it matter where stock-trades occur, investors and public companies?
It does to the stock exchanges. The explosion in passive investing has driven trades toward the last price of the day, found in stock-exchanges’ closing auctions.
Index and Exchange-Traded Funds need to track a benchmark in most cases. The bane of passive investing is skewing from the mean, called a tracking-error. The last price of the day is the reference price, the official one. Money pegging a benchmark wants it.
It’s been profitable business for the big exchanges because they charge the same price to buy or sell into the close. Often at other times there’s a fee to buy but a credit to sell (they say “adding and removing” but don’t get lost in the jargon).
Orders to buy or sell may be “market-on-close,” (we’ll call it “the mock”) meaning at the best bid to buy or offer to sell as determined by matching up supply and demand, or “limit-on-close,” orders buying or selling at a specific price or better to end the day.
If you’re nodding off now or looking for the latest news on who might’ve won the Iowa Caucus, stay with me. There’s an important market-structure lesson coming.
Cboe (the erstwhile Chicago Board Options Exchange) operates four stock markets and just received SEC approval to be part of the closing auction, formerly controlled by the NYSE for stocks listed there, and the Nasdaq for stocks listed there.
The auction will occur at Cboe’s BZX market, likely at a set fee per share. It’s important to know that BZX encourages orders to sell, paying $0.30 per hundred shares, or even $0.32 if the shares first came from retail traders. That means firms like Two Sigma might buy trades for $0.15 from Schwab and sell them at BZX for $0.32.
Why would an exchange pay so much for a trade? Because it sets the price – and that’s valuable data to sell, worth more than the cost of paying for the trade.
But I digress.
So the Cboe will now use prices from the NYSE and the Nasdaq to match trades market-on-close for reference purposes. No short trades, no limit orders. Only what the market giveth or taketh away.
Naturally, the NYSE and the Nasdaq opposed the Cboe plan. We wrote about it all the way back in Aug 2017, describing the cash at stake then. The biggies argued expanding access to the closing auction would fragment liquidity.
Anyone can use order types from all the exchanges to fill trades. What difference does it make where trades occur if the rules from the SEC say the behavior must be uniform?
It’s like those heist movies where the robbers huddle beforehand and say “synchronize watches.” The market is a collection of synchronized watches at the close.
But overlooked amid the market mumbo-jumbo are the effects on trading the rest of the time – and we need to understand, investors and public companies.
Phil Mackintosh, now chief economist at the Nasdaq and always an interesting read, says, “The data show there are a lot of other investors, traders and hedgers who are also using the close because it’s a cheap way to get sizable liquidity with minimal market impact.”
True enough, it’s not all passive. By the way, MSCI indexes rebalance for the quarter today. The issue to us is the way that much of the trading throughout the rest of the day is an effort to change the prices of big measures into the close.
Traders know money chases reference prices. So they change prices the rest of the day by running stocks up or down, and trading index futures, options, options on futures, or baskets of ETFs, creating divergences to exploit.
This becomes the market’s chief purpose – skewing prices and bringing them back to the mean (the hubris here is a story for next time). Everyone thinks it’s fundamentals when the behavioral data show how pervasive this short-term pursuit has become.
How to solve it? Disconnect markets. That alone would halve the arbitrage opportunity.
Since that won’t happen, the best defense is a good offense. Know what all the money is doing, all the time (we can help), and you won’t be fooled. Or mocked.