Written by Philippe Theyras, Head of Market Analysis, Itiviti
On June 11th 2019, the European Securities and Markets Authority (ESMA) published its final report on periodic auctions for equity instruments, in response to a call for evidence issued in November 2018. The aims of this assessment were to develop a better understanding of periodic auctions, and to determine whether they constitute a loophole to circumvent transparency obligations, especially in regard to the Double Volume Caps (DVC) restrictions on dark trading.
The final report from ESMA summarizes the feedback received from market participants. It also provides clarity on key issues and identifies the areas where further regulatory guidance will be released in the coming months.
As many as 27 participants have submitted their views to ESMA. Respondents included trading venues, members and representatives of the buy and sell side communities, principal traders, regulatory agencies and academics. A majority of stakeholders welcome the emergence of periodic auctions and embrace the periodic auctions as an innovative trading mechanism. Nonetheless, critics of the system practise remain, as demonstrated by the divergence of opinions seen in the public responses to ESMA’s consultation.
We have taken the publication of the final report as an opportunity to explore the market structure changes that have resulted from the introduction of periodic auctions and the regulatory challenges that it poses. The first blog will deep dive into the market structure changes.
What are periodic auctions?
Periodic auctions, also called Frequent Batch Auctions (FBAs) are lit order books that can run thousands of very short auctions throughout the day with a matching process quite similar to a conventional auction. The auction period varies between 25 ms and 150 ms according to the configuration of the platform and the random feature (see chart below). FBAs include Cboe Periodic Auctions, ITG POSIT Auction, Nasdaq Auction on Demand, Turquoise Lit Auctions, UBS MTF, GS Sigma-X MTF and MS MTF.
Source: Nasdaq Auction On Demand (See Here)
The auction duration has been criticized as being too short and the question of introducing a minimum duration for the call period has been raised. The main argument in favor of this is to attract more liquidity and to give more time for algos to interact. But as one respondent argues, “a periodic auction lasting 100 milliseconds is 806 times slower than the London Stock Exchange's Central Limit Order Books (CLOB) latency”. More generally, it is not a short period in the current electronic trading environment and the argument of liquidity may also be used to defend the established order: a “long” auction could disincentivize it. Ultimately, the auction duration should be decided by the venues themselves. On this matter, ESMA does not consider it necessary to take further action.
MiFID II and MiFIR do not provide a definition of periodic auction trading systems as such. In the call for evidence, ESMA identifies the duration and scheduling factors as the two main differences between FBAs and traditional auctions (opening, closing and intraday) - termed conventional periodic auctions (CPAs). The comparison is not straightforward. A majority of respondents agree and also indicate that both characteristics have to be met concurrently. One respondent observes that conventional auctions are not always scheduled; for instance, an auction can be held after a volatility event; which is itself the result of the placement of an order into a market. Most respondents also highlight a third characteristic linked to the fact that FBAs operate in parallel with CLOBs. In their final report, ESMA notes they are working towards providing further clarity on the definition of, and distinguishing between, FBAs and CPAs.
How does market share evolve with regards to the DVC issue?
The sharp increase in the use of periodic auctions following the implementation of the Double Volume Caps (DVC) drew considerable attention from ESMA. According to data gathered by the regulator, FBA trading increased from 0.5 % of share trading in January 2018 to 2.4 % in August 2018. After the first suspensions expired in September 2018, there was a decline in market share. FBA activity has since stabilized around 1.7 %, which means that it is far from being a major feature of the equity trading landscape (see graph below).
Source: ESMA final report (See Here)
The data suggests that FBA activity is correlated with the first wave of DVC but also that it remains attractive in the absence of a suspension of the waivers. For some respondents, periodic auctions are a real additional source of liquidity, i.e. it reflects the demand for urgent low impact executions below Large-in-scale (LIS). ESMA concludes that it is not a tool just designed to circumvent the DVC. This is in line with the analysis released by the UK Financial Conduct Authority (FCA) in June 2018.
What are the main factors driving the growth of FBAs?
The use of Frequent Batch Auctions has emerged as a divisive issue between incumbent market operators and users. The former group point to the DVC bypass reason (without providing any new data) while the latter highlight the high level of execution quality benefits of FBAs, including mid price matching inside or at EBBO and often between two ticks, the randomization feature (acting as a symmetrical speed-bump), no imbalance data reducing information leakage and most importantly the low market impact as illustrated in the graph below.
Source : big xyt (See Here)
On a theoretical level, FBA may appear as an attractive alternative to continuous-time CLOB trading which has a mathematical flaw. Trades are processed trades serially (one-at-a-time) while time is treated as a continuous entity. This inevitably leads to a race for speed and a misunderstanding of pre-trade transparency. As explained in an academic response, “in a world of latency - the best you can hope for is to know where the market was a latency ago, and hope that the market will still be there a latency from now!” Therefore, a discrete time trading feature, such as FBA, transforms competition on speed to a competition on price.
The trading performance benefits offered by periodic auctions has led to the adoption of these venues by market participants, and ESMA has concluded that it does not contravene the DVC mechanism. Periodic auctions still have a small market share, and excess regulation is viewed as a hindrance to innovation. The regulator also has no problem with the “short” duration of periodic auctions. It is good news that ESMA did not take a hard stance and will rather produce further guidance to better define their specificities.