August 16, 2017

Auctioning Profits

What’s the closing auction worth?

A member of the investor-relations profession last week posted a story for community discussion on a CBOE BATS proposal to open day-end auctions to exchanges that don’t have listings.

Right now rules say only the listing venue, largely the Nasdaq and the NYSE, can host end-of-day trades that many investors count on for prices that best track broad measures like the S&P 500 and Dow Jones Industrial Average.  BATS is trying to change it.

First, what’s the closing auction? Near the end of the trading day, exchanges that list stocks start providing data on buy and sell orders that want to get the last and best price.  All three big exchange groups host them – the NYSE, Nasdaq, BATS – and new entrant IEX has gotten tacit approval for its closing auction ahead of listings.

All three big groups have rules around what kinds of orders are included, but generally they are “market on close,” or a trade that takes the best price to buy or sell, or “limit on close” trades that only execute if the specified price matches the market.

BATS is the earliest in providing data and starts sending five-second updates on buy and sell imbalances at 3p ET. The NYSE and the Nasdaq follow at 3:45 and 3:50p ET respectively, also every five seconds.  Have you noticed how prices can change significantly in the last hour and especially last 15 minutes? There’s your reason.

Oversimplifying, right at 4p ET everywhere, buy and sell interest is matched at an average price. The NYSE calls it an auction, BATS uses a Dutch Auction (averaging all prices, excluding outliers) and the Nasdaq calls it the Closing Cross.

Now it gets interesting. This mass closing trade for NYSE stocks happens only at the NYSE and ditto for Nasdaq-listed shares.  BATS has proposed to the SEC that they be able to match trades in NYSE and Nasdaq stocks in the closing auction.

This at root is why exchanges want your stock-listing, public companies. It’s where the money is made.

The listing exchanges are outraged. Who can blame them? All the more when you understand the economics. Save at the open and close, trading at the exchange is a low-margin and often money-losing business.

They pay high-speed firms to set the best bid to buy or offer to sell. They’d flinch at my description but that’s the truth. Rules cap what exchanges can charge for trades at $0.30/100 shares.  But they can pay incentives well beyond that. The big exchanges have incentive tiers and platforms for high-volume customers paying up to $0.45/100 shares. They lose money on these.

Why would they do that? Because all trades in your stocks must match between the NBBO – the national best bid or offer. It’s a central tenet of Reg NMS, which governs markets. Exchanges pay some traders to be honey that attracts the bees.

The exceptions are the opening and closing auctions. Here, all the order flow ends up between the bid and offer by rule at some average price, and exchanges do not pay incentives because they have a monopoly in their listed stocks.

In fact, they charge about $0.09/100 to both the buyer and the seller ($0.18 total), meaning they make more in the auctions than any other time. Easy money.

Nearly 10% of trading occurs in the closing auction because it offers indexes and ETFs trying to “peg the benchmark” the best chance of getting prices nearest the index they’re tracking.

With about 6.5 billion shares trading daily marketwide and roughly 2.6 billion of it at the NYSE and Nasdaq, and 10% of that in the close, you can get to roughly $150 million of potential revenue annually for the big exchanges in these auctions. These are our estimates, mind.

But that’s not the half of it. Literally. Hosting the closing auctions drives two other vital revenue streams for big exchanges. First is a share of revenue from the Consolidated Tape Association.

The Tape Plan, as it’s called, divides revenue from data generated by stock tickers (you look up a ticker, you’re driving exchange revenue). It’s hundreds of millions of dollars yearly for members.  It’s apportioned by quote-share and trade-share in stock symbols. The closing auction gives the NYSE and Nasdaq a disproportionate part.

Second and data-related, prices from the closing auction comprise valuable data, and brokers are required to buy it to prove they matched best prices. The most precious product exchanges sell is data. And it’s vital to profits, since trading is a commodity.

The Nasdaq earned $108 million of net income in fiscal 2016, NYSE parent ICE, which is less reliant on equity trading, about $250 million. Take $250-$300 million (that they split) away – figuring data is double closing-auction trading revenue – by fragmenting the close, and the bottom line for both is hampered.

It’s an estimate. But follow the money and this is where it leads.

I can make the argument both ways. Fragmenting imbalance data by spreading the auctions out could mean mispricing. That to me is the leading argument against the BATS proposal.  Conversely, BATS would argue that it’s using the same pricing data so it merely increases access and removes an unfair advantage from listing exchanges – which could help you pay lower listing fees, issuers.

The bottom line is you need to know how the market works. Otherwise you cede control of it to parties wanting to profit on your prices.  That’s not in the best interest of your shareholders.

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