LSE Closing Auction - How it works

Different stock exchanges have different ways of determining the close price of a stock (i.e. different close mechanisms). These mechanisms vary in complexity, but there are a few main, and widely used types. In the simplest form is the last traded price which is used for stock exchanges such as that in New Zealand. For this type it is straightforward, the last trade price is the closing price. For other exchanges are slightly more complex methods which involve calculating the VWAP (Volume Weighted Average Price) for either the whole day, or a period preceding the close. Understanding the closing auction period is not easy by any means - don't be surprised if it still doesn't all make sense, but this should go some way towards explaining it.

3 Main types of UK market systems

For the UK there are 3 types of trading system which have different ways of determining the close price.

- SEAQ (Stock Exchange Automated Quotation), which is used for some UK AIM companies. For companies to be eligible, at least two market makers must exist.  This uses non-electronic market making. The SEAQ system uses the mid-price (or current price) as the close price.

- SETS,  which relies upon a more complex 'Auction period'. This is used for all the main indices such as the FTSE100, FTSE 250 and liquid AIM stocks. This uses electronic market making. This uses an 'Auction period' to determine the close price

- SETSqx: this is for main market stocks that are not covered by the SETS system, or less liquid AIM stocks. This uses non-electronic market making. This uses an 'Auction period' to determine the close price

For SEAQ, working out the final close price is therefore quite simple - for SETS and SETSqx, the process is not as simple. In fact, the Auction period is one of the most complex types of close mechanisms. For the UK markets, the Auction period starts at 16:30 and typically lasts until 16:35 when a close price is derived. No trades are completed during this period, until auction matching at 16:35.

The Auction Period

 When using the action mechanism, there are 8 possible pathways that can be used to determine the closing price. Admittedly, this is not easy to explain, nor is it important knowledge, but is is not widely covered, especially in understandable terms.

In brief, for SETSqx there are two board-stroke scenarios that encompass the 8 pathways. These are
1. With registered market makers, and, 2. Without registered market makers
1. If trades are submitted during the closing auction, the price will result from calculations to do with these. If no trades are submitted the closing price will be based on the mid of the best market maker bid offer price at the end of the closing auction.
2. If trades are submitted during the closing auction, the price will result from calculations to do with these. If no trades are submitted then the closing price will be determined by the stock's last automated trade

An auction consists of two phases; the Call Phase and the Price Determination Phase. During the call phase, orders can be entered, changed or cancelled, but no trades are completed. Essentially during the Call Phase, there is a call for orders. A preliminary indicative price is also found. The subsequent phase is the Price Determination phase. During this stage, no orders can be changed, entered or cancelled. An order-matching algorithm is run which seeks to find a price at which the executable volume is maximised. In other words, the price reached is the price at which the highest volume takes place. Other conditions are also sought after in the final price. A 'minimum surplus' and accurate 'market pressure' are two of these. The final auction price is displayed as an 'Uncrossing Trade' - UT.

There is a catch though. If the auction match volume is less than a pre-determined multiple of the Normal Market Size [NMS] (this can be found on websites such as lse.co.uk on the company's page. Denoted 'market size), then auction matching will not occur. The required multiple for shares with a NMS in excess of 5000, is 0.5*NMS. Therefore if the NMS is 24000, the required multiple is 12000. For shares with an NMS below 5000, the aggregate executable volumes must be at least 2500. All orders that are not executed during the auction process are left on the order book for the next trading day.

What if the required multiple is not met?
For the SETS system, at 16:20 each day, the VWAP period commences. Between 16:20 and 16:30, a VWAP figure is calculated, based on all trades during this 10 minute time slot. If the multiple is not met, and the orders are not matched, the VWAP value becomes the closing price. If no trades are made during the VWAP period, the last automated order book trade will become the closing price for that stock.

During the auction phase there are things called Random End Periods (REPs). These last a maximum of 30 seconds and are an attempt to reduce price manipulation in the auction. The random aspect is in terms of time. The REPs are placed at the end of each segment of the auction period. By now knowing the exact time, the system is less open to manipulation by traders. This is because manipulators will be discouraged from entering trades and cancelling them due to the risk of getting stuck in the shares by an unexpected random close.

What are Price Monitoring Extensions (PMEs)?

PMEs don't exist on the SEAQ system, only on the SETS and SETSqx systems. To start, we must recall that the whole purpose of an auction is to generate a stable, reliable closing price. PMEs are initiated when the process fails to find one. Without getting too technical, the first PME can be initiated at 16:35, after the end of the typical auction period. It is initiated if the price found during the preceding 5-minute window is significantly different from the reference price. The reference price is the price just before the stock went into auction. If the difference is too significant, 'price tolerance' is said to be broken and the PME is started. The accepted tolerance is dependent upon the section that the company operates in.  The initiation of PMEs warrants an immediate RNS to the market. Below is the text found in a PME RNS.
 
"Auction call extensions give London Stock Exchange electronic order book users a further opportunity to review the prices and sizes of orders entered in an individual security's closing auction call before the execution occurs. A price monitoring extension is activated when the matching process would have otherwise resulted in an execution price that is a pre-determined percentage above or below the price of the most recent automated execution today."
 
The RNS highlights to potential investors that they may be able to get a good deal buying or selling said stock and this encourages their involvement in stabilising the price through inputting acceptable orders. As with other parts of the auction, each PME is followed by a REP. Should a stable price still not be found following the first PME, a second PME can be initiated at 16:40, but this is the limit. There can only be 2 PMEs: in such an instance, the final closing price will be generated at around 16:45-16:50 when factoring in the REPs. If, during the two PMEs, no further orders are entered, the original auction price will be accepted. This final closing price will remain outside of price tolerance levels.
 
An example: A stock was trading at -5% at 16:29, just before the auction period. During the auction period, trades get entered at the price equivalent of -20%. This will likely trigger a PME to try and relieve the price intolerance. You may wonder, why should this occur? One reason it may occur is if the share has a wide spread during the day. If the bid price is far below the mid-price, this could trigger it. Alternatively, the company may release a negative RNS at 16:30 that sets off a decline during the auction period.
 
What are Market Order Extensions?
 
A Market Order Extension (MOE) can also be initiated at 16:35 (At the end of the Auction call period), which lasts 2 minutes plus a REP. These are not very common, and are not worth worrying about, but basically they are initiated when all market orders cannot be matched. They allow for the further entry and deletion of orders. They occur prior to any PMEs, and if the MOE yields a satisfactory closing price, no PME will be initiated. However, if the price tolerance levels are breached, a PME will be initiated. This can extend the whole auction process for a stock by a (maximum) extra 2 minutes 30 seconds.