October 31, 2012

The Auction


What a Halloween week. To our many friends, clients and colleagues on the Atlantic seaboard assailed by Hurricane Sandy, we in Denver are rushing sunshine your direction.

Exchanges are hoping for sunshine too as trading resumes. It hinges on opening auctions. That gives us the creepy-crawlies, as though black cats were crisscrossing ahead as we ducked from ladder to ladder to avoid the falling sky.

Why? BATS Exchange saw its IPO torpedoed when the opening auction went awry. Flaws in the Facebook opening auction at the Nasdaq delayed quotes, and the fiasco lingers in recriminations and lawsuits. Knight Capital Group had bad software derail an algorithm hitting opening auctions.

We should note “closing auctions” too, since trading days begin and end with them. Some, like the Nasdaq, call them the opening and closing “cross” – not as though it’s catechism but because of what happens.

As Sandy stomped through Long Island Sound, the big equity exchanges including NYSE, Nasdaq, Direct Edge and BATS, were plotting how to get a good auction going today to restart markets dormant since Friday.

Now, stay with me. We have one aim: To explain why the Halloween auction is vital – and risky – and why auctions are both linchpins to price-discovery and the market’s Achilles Heel.

Auctions are rallies to kick off and conclude trading days. Think water-skiing off the dock. If it goes well, you’re skimming. If not, it’s a bad. It’s remarkable that they skim 99.5% of the time, or more. Without successful auctions, markets would lack equilibrium, liquidity and clear price bands. We’ve seen the results of failure.

The major listing exchanges (NYSE, Nasdaq) host auctions for every traded equity. Auctions form well before market open or close and gather steam as data about buy/sell interest and imbalances is disseminated.

That’s why today’s is vital. We’re restarting equities not after a weekend or holiday in everybody’s algorithms (it’s the same in our analytical algorithms). We’re jumping the entire US equity market back into a fray that never stopped in other asset classes and markets globally. It’s like the TV show Wipeout. The timing has got to be right.

In a sense, auctions are a microcosm of everything that’s both right and wrong about today’s equity-market structure – and thus they are its Achilles Heel. What’s right is that auctions are the igniter, the spark, to modern markets that match masses of different purposes and time horizons with incredible efficiency.

Auctions handle both “market” orders that have no price but take what the market gives, and limit orders, ones with specific prices. The confluence of market and limit orders in an environment of rapid re-pricing and transient intermediation is what detonated the Flash Crash of May 6, 2010. Auctions organize chaos to prevent cataclysm. Auctions offer certainty. They balance supply and demand.

We come to the Achilles Heel. We had an ancient and majestic 1936 Caterpillar RD6 when I was a kid growing up on a cattle ranch. A giant tracklayer that could pull anything. You first had to start its small gas engine to warm up the big diesel’s manifolds. You went out front with a handle and spun the crankshaft for the gas engine, hoping it wouldn’t backfire and break your arm. After a bit, you shifted gears to mesh the little engine and crank the big diesel to life.

It was a tricky operation. Without that starter engine, the big tractor was nothing and the power it possessed was wasted.

That’s the equity market. Without auctions to warm the manifold and get the machinery humming, we are one backfire away from broken limbs and wasted power.

So let’s hope this Halloween is all treat and no trick.

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