C&B Notes

Passive’s Impact on Liquidity

As passive investment strategies become a larger part of total volume, the windows of “best” liquidity have become more concentrated.

A seismic shift towards exchange traded funds and other index-tracking investment vehicles has heightened the importance of the last half-hour of the U.S. trading day, from 3:30 to 4pm, when these passive funds typically conduct most of their activity to accurately match their benchmarks…  “This dynamic is a pretty big story,” said Bob Minicus, head of global equity trading at Fidelity.  “We view the close as an opportunity.  As more volumes migrate towards the close, we will follow it.”  Some traders and investors complain that the funneling of activity into the last half-hour of the day — which comprises nearly a quarter of all U.S. stock trading — is sucking liquidity away from the middle of the day, when making large trades can now have a noticeable market impact.  Indeed, what traders refer to as the “liquidity smile” formed by the pattern of trading volumes has recently become more pronounced and turned it into a “liquidity smirk” due to the lopsided importance of the 3:30-4pm trading window.  Some now fret that, with so much money sloshing around in a small window, it increases the risks of market mishaps.

Sucking more liquidity away from midday trading heightens the risk of making markets more prone to volatility around lunchtime.  The share of U.S. stock trading that happens between noon and 2pm has dipped from more than 23 per cent a decade ago to about 20 per cent, according to Credit Suisse.  Given the clear trajectory of the trend, more midday volatility could start to become more apparent in the coming years.  “It’s become a self-fulfilling prophecy.  The liquidity feeds on itself,” said Todd Lopez, head of electronic trading for the Americas at UBS.  “The concentration around the close is likely to accelerate as more people try to minimize their market impact.”  There have already been some examples that the thinner midday trading can cause problems, most notably the “flash crash” of 2010, when the U.S. stock market suddenly swooned at 2:45 pm.  While the blame fell primarily on a badly executed order by a big asset manager that was exacerbated by high-frequency trading, some experts say the severity was worsened by the thinner early-afternoon liquidity.

The first and last half-hour of the U.S. trading day now accounts for 39.6 per cent of all volumes, up from 31.5 per cent a decade ago, according to Credit Suisse data.  A decade ago about 16 per cent of all trading happened in the final 30 minutes, but that rose to more than 20 per cent in 2012, and almost 25 per cent this year.  The closing auction alone — when most ETFs do their re-balancing — now accounts for 8.2 per cent of volumes in 2018, up from 3 per cent in 2007.


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