By Gary Stone, Chief Strategy Officer, Bloomberg Trading Solutions, Tom Kingsley, Head of the APAC, Bloomberg Tradebook, Gabriel Kan, Senior Quantitative Analyst (APAC), Bloomberg Tradebook
Liquidity and spreads have always been a challenge when investing in Asia’s equity markets. Some of this challenge is being alleviated by Asia’s closing auctions growing into a significant liquidity event. Averaging 3-5% of average daily volume (ADV) in 2009, during Q1 2015, the closing auctions across developed, developing and emerging Asian markets account, on average, for almost 13% of the average daily volume. Given the importance of the closing auction, the Hong Kong Stock Exchange is planning to re-introduce one in 2016. Traders, whether they are seeking liquidity to accumulate or distribute an investment or replicate an over-the-day execution, simply cannot ignore the closing auction anymore. The new challenge, however, is how to trade them. At Institutional Investor’s June 2015 Asia Trader Forum in Hong Kong, more than 60 head traders were surveyed – they said that extreme price movements were their biggest concern in the auction process.
We would like to introduce the 12% “Rule of Thumb.” Price movement is impacted and the question from a quantitative perspective is: Can we determine the maximum amount that can be allocated to the closing auctions while minimising potential market impact? The answer involves first estimating closing auction volume and then determining an optimal cap on the participation rate.
Estimation of the closing auction volume
Whether expressed as shares or as a ratio of the day’s total volume, closing auction volume is volatile (Figure 1). To estimate closing auction volume, a predictive model must not only provide a reasonable volume prediction, but, more important, it must minimise and, if possible, avoid overestimation. Overestimation will drive adverse impact. Ideally, if the model misestimates the volume, it should err in a way that minimises tail risk, i.e., does not cause the trader to introduce significant market impact and drive the closing price.
Our quantitative research suggests that estimating the closing auction volume requires an estimation of “today’s volume” combined with other factors such as yesterday’s closing auction volume, the number of trades on the consolidated tape and special events such as month-ends, derivatives expiries, Japan special quote days and index rebalancing days. A model based on these and other factors appears to stabilise around midday, implying that traders can start to allocate shares into the closing auction based on midday information.
Formulating a “Rule of Thumb”
To estimate an optimal participation rate, we used actual ASX execution data over the past year. We believe that the ASX is a good proxy for the rest of Asia’s closing auctions. It used to be that Australia’s markets resembled Europe. However, we see the closing behavior maturing toward the ASX as the close has become a benchmark and the closing auction a significant ADV liquidity event. We found in Hong Kong, Singapore, Japan, South Korea, Taiwan, Malaysia, New Zealand and Thailand that traders’ participation in the closing auctions was skewed heavily to the left.
To measure the market impact at the different participation rates, we benchmark the closing price with respect to the last traded price in the continuous trading period. This is analogous to the arrival price benchmark in the common transaction cost analysis. (Figure 3.) shows the average shortfall measured in bid-ask spread for closing auction orders. The shortfall is about zero when the average participation rate is less than 7%. However, the shortfall starts increasing when the participation rate rises above 7% and the average shortfall crosses the zero mark near 11% participation. The 25%-tile lower band rises above zero when participation rate reaches 13%.
The 12% Rule of Thumb
Taking the middle point establishes our “Rule of Thumb.” Our statistical analysis confirms that institutional traders are currently not leveraging closing auctions to their full capacity. The Australian Stock Exchange was used as a proxy; the data suggests that traders should cap their closing auction order size at 12% of the predicted closing auction volume to avoid significant market impact. We believe that this rule of thumb generally applies to the other markets.
In practice, the “Rule of Thumb” works as follows: Take the lesser of 12% of the predicted closing auction volume and 12% of your order and allocate that share amount to the closing auction.
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