With John Comerford, Instinet Head of Global Trading Research
The conventional wisdom is that the application of Rule 48 on 24th August had a major deleterious effect on pre-trade transparency of the open on the New York Stock Exchange (NYSE). From the NYSE’s perspective they invoked Rule 48 and instigated the necessary manual processes in order to reduce volatility around the open.
However, our research indicates that neither of these statements is entirely true. Rule 48 relieves electronic market makers of a certain subset of their duties. But when we analysed the actual data, we found that almost every single stock showed pre-opening indicative prices and volumes, so in fact there was pre-open transparency reasonably akin to that which is found on any other given day. There were a few notable exceptions, but materially most names had the same pre-trade, pre-open prices and volumes. The one major caveat was that they just stopped at 09:35. This meant that on the NYSE there were opening volumes, volume indications and price indications on all these names, right up until 09:35 and at that moment approximately 60% of stocks hadn’t yet opened. This caused a significant problem.
The main consequence of invoking Rule 48 is that if a stock is going to open significantly up or down, under normal circumstances the market makers have to check with the floor official and receive manual approval in order to open that name. Once Rule 48 has been implemented, there is no further duty to do so, so theoretically stocks can be opened up faster. But clearly on that day the NYSE names did not open quickly enough.
We also observed through our analysis that this change did not reduce volatility. We compared the opening prices to the stock market at 10:00 and by that time everything had returned to normal and there was no significant difference between the electronic NASDAQ open and the manual NYSE open. The consequences of this could be wider reaching than just what happened on that particular day and the slight disagreements that occurred between NYSE and NASDAQ. This is because we were witness to a far broader picture of the industry which pointed out that all the different assets that are derivatively priced (primarily the futures and options pricings), are all governed by different sets of rules around opening, trading halts etc.
There are therefore some real parallels to the flash crash in that different rules regulate different markets. There is growing pressure within the industry for greater harmonisation across asset classes especially those asset classes that are materially the same. The difference is in how the various exchanges and asset classes address volatility and allow order market functionality during the open, at the close, and during the trading day.
Time for regulation
Their participation, whether active or passive is needed, together with retail, because retail participants are more active users of, for example, stop loss orders.
There are always going to be disparate interests between the parties. The market makers are going to have their own interests and obligations and considerations for those obligations. The exchanges have to make sure that there is a balance between the consideration that they get for making markets and the obligations that they then have to uphold to get said considerations.
The open is very different to the close, as there cannot be discontinuities on the close. The close tends to be a liquid area – if their price moves, it tends to be liquidity driven.
The challenge is that we have continuous trading rights after stocks open, and so the open itself is as much a period of price discovery as it is one of plain liquidity discovery, unlike the close which is more about liquidity. From there we go straight from that price discovery point into continuous trading, and that transition is a challenge when there are disparate opening techniques and disparate opening times.
Competition driving change
There is much that can be learned from other markets. The US market is very complex but the systematic opening up of exchanges to competition has encouraged a tremendous amount of technological innovation, which has helped the market. The London Stock Exchange had to transform itself because of global competition and if the NYSE hadn’t had the competition of NASDAQ for the opening print, then New York would never have changed.
Intra-country exchange competition is really valuable for investors on the whole, because firms can decide to list elsewhere. This does cause more friction, but a large number of firms have listed outside their country of origin.
Other competition-driven changes are taking place – there is talk in London of intra-day auctions and the NYSE is also considering different types of auction.
However, there comes a point in the opening process where it isn’t possible to allow pure competition. As an industry, we have to ask market participants to come together to agree on some broader standards. Every party, every exchange, the sell-side and the buy-side all have similar interests – they are much more united than divided.
The flash crash was not good for the industry but the industry rallied as a result and the rules are now much more harmonised – which could be another positive opportunity.
24th August may have as many consequences for global markets and multi-asset and cross-asset class trading as there were from the flash crash. It could be that the events of 24th August are the catalyst which encourages standardisation of process and protocol around the open and closing auctions.
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