The trading day lasts anywhere between six and eight-and-a-half hours. Increasingly, however, the only bit that matters is the final few minutes. This shift – much of which is down to the rise of passive investing – has a huge impact on intraday trading liquidity in equity markets. 

And a new study argues that the rapidly rising share of trading taking place during closing auctions – which is driven by passive flows – is leading to higher transaction costs and lower liquidity for investors, as well as impaired price discovery and reduced market efficiency. 

The research on three major European equity markets highlights how closing auctions account for a third of all daily trading volume, a dominance which may in turn negatively impact liquidity and price discovery. The research chimes with previous reports that indicate price moves during auctions revert overnight due to the liquidity dynamic. 

“Due to the rise in passive investments and regulatory changes, equity markets worldwide have witnessed substantial shifts of trading volumes to the close,” note the authors of the report, Shifting Volumes to the Close: Consequences for Price Discovery and Market Quality , Micha Bender, Benjamin Clapham, both of Goethe University in Frankfurt, and Benedikt Schwemmlein of the German Bundesbank. 

Passive investing has boomed in recent years, drawing in trillions of dollars into index funds. Whilst generally seen as a positive, it has attracted some criticism from investors who fear it may have grown too big. A study from December explicitly warned about passive investing, arguing that increased indexing “appears to be undermining the efficient markets hypothesis that supports its viability”. 

Index funds usually buy and sell shares at the close, as the last price of the day sets the benchmarks for the fund to match. This liquidity-driven buying and selling effectively distorts the price of shares, argue the authors of the new study. 

In the major European markets in question – the FTSE, DAX and CAC, the share of trading volume executed in the closing auction accounted for 40% to 55% of daily trading volume in 2023. Of particular note was the jump for FTSE stocks – closing auction share rose from 31% at the beginning of 2019 to 55% at the end of 2023.  

This shift of volume to the close raises the question whether this comes with potential negative effects for market efficiency.  

The report says: 

“First, the mostly liquidity-driven trading interest of participants in the closing auction might lead to distortions of the closing price and deviations from the fundamental value due to short-term supply and demand imbalances caused by, e.g., one-sided order flow from index tracking funds.  

“Second, as liquidity begets liquidity, the rising trading interest at the close might have negative effects on liquidity and volatility in the continuous trading session of the remaining trading day.” 

On the first point, the analysis provides evidence that these high-volume closing auctions lead to closing auction returns that are “systematically reversed overnight”.  

They write: “Specifically, we find that 14% of the closing auction return are reversed overnight and that this reversal persists for more than two hours on the next trading day. The price distortion is even stronger for the stocks with the largest closing auctions in our sample where up to 24% of the auction return is reversed. 

Previous studies have shown “similar but even stronger” evidence for distortions of closing prices in the US stock market. Two studies from the last couple of years have shown closing auction returns are “almost entirely reversed overnight or at least within the next few days”. 

“Increasing closing auction volumes, index rebalancing days, and high intraday returns are the main drivers of these reversals,” they add. 

On the second point, whether high-volume closing auctions adversely affect liquidity and volatility during the rest of the day, they again find evidence that it has a negative impact. Particularly high closing auction volumes decrease liquidity in terms of both spreads and depth during the entire continuous trading session. Effectively trading volume shifts away from continuous trading to the closing auction, due to, for example, the “liquidity begets liquidity” effect.  

“Our findings show that the shift of trading volumes towards the close comes with negative effects for market efficiency. Specifically, it increases transaction costs for investors during continuous trading and distorts the closing price, being the most important price of the day for markets and valuations,” the report states. 

This new paper chimes with previous studies, such as this 2019 study, updated last year, which also showed that auction price moves are prone to reversals overnight. Closing auctions accounted for 7.5% of daily volume in 2018, up from 3.1% in 2010.  That figure seems to have risen to about 10% by 2019. Today about a third of all S&P 500 trades take place in the last ten minutes, according to BestEx Research, with the final minutes of continuous trading in the US running alongside the closing auction. 

What else is behind the shift to closing auctions? 

Besides the growth in passive investments, the introduction of MiFID II accelerated closing auction volumes by limiting over-the-counter and dark pool trading. 

Moreover, the researchers note that the avoidance of HFT arbitrageurs provides a potential third explanation for increasing closing auction volumes since HFTs trade a lot less in closing auctions. Effectively by trading in the closing auction other investors can swerve these traders.  

A fourth explanation for rising closing auction volumes is the “liquidity begets liquidity” concept, which has been well documented and researched. 

Neil Wilson

Chief Market Analyst at Finalto

All opinions, news, research, analysis, prices or other information is provided as general market commentary and not as investment advice and all potential results discussed are not guaranteed to be achieved. The information may have been derived from publicly available sources, company reports, personal research, or surveys. Past performance is not indicative of future performance. Trading carries risk of capital loss. Service available to professional clients only.