What you need to know about the Hong Kong stock exchange restoring closing auctions

The Hong Kong stock exchange (HKEx) restored its closing auction system on Monday after a seven-year hiatus. Here is what you need to know about the move.

What is a closing auction?

A closing auction is a process of setting a closing price for a security and allowing it to trade at that price. Such a mechanism can enable large institutional investors to buy stocks at a set price after markets close instead of trying to put in orders just before the close of trade when volatility can be high.

It's not uncommon, with stock exchanges in most developed markets, except Hong Kong, and many emerging markets providing for a closing auction of some sort. Among major emerging markets, only India and China don't have a similar system.

Analysts weren't necessarily concerned about reintroducing a closing auction in Hong Kong.

"This is a system that internationally is more a rule of thumb for other exchanges," Gavin Parry, managing director of brokerage Parry International Trading, told CNBC's "Street Signs" on Monday.

Why did HKEx get rid of it?

In early March of 2009, as the global financial crisis was unfolding, shares of HSBC plunged more than 20 percent in one day, with much of the largely unexplained drop coming in the final minutes of the closing auction. Because HSBC was heavily weighted in the Hang Seng Index, the benchmark also took a tumble.

Although suspicions of market manipulation were never proven, the drop brought concerns about the closing auction front and center. Traders had previously complained that securities would move sharply during the auction and that prices could be manipulated.

That spurred HKEx to suspend use of the auction.

Why is HKEx bringing it back?

HKEx was concerned about remaining competitive with other exchanges that offer the ability to trade at a security's closing price, something that institutional investors often require.

The exchange noted that trading at the closing price can be an investment mandate for many passive equity funds, representing around 10 percent of equity flows daily, a figure that can jump to more than 30 percent on days when funds rebalance to match an index.

Without allowing trade at the closing price, index funds can have more tracking errors, hurting investment returns, HKEx said in a presentation in June.

Parry cited another reason to bring back the closing auction: "What they're really trying to do here is curb volatility, particularly for the closing price," he said.

Without the auction, the market saw a lot of volume into the last minute of trading to try to capture the closing price, he noted.

"It's all about instilling confidence that the market will basically curb some of these extreme volatile moves for price discovery at the close," Parry said.

What’s different this time?

Many of the changes were meant to prevent gaming the system by either manipulating the eventual closing price or front-running it.

One major change was only allowing securities to move by 5 percent, either up or down, during the auction period. A reference price would be set in the one minute period after the market close by taking the median of five nominal prices in the last minute of the regular trading session.

Previously, the largest order for a share determined a stock's closing price, making it vulnerable to manipulation, according to a South China Morning Post report.

The decision on a 5 percent band met with pushback from some traders, who would have preferred a 2 percent band, but HKEx noted that most markets don't have a closing-auction price limit and that 5 percent was among the tightest bands in markets that implement a closing auction system.

The eight-to-10 minute closing auction period would also include a two-minute period that wouldn't allow orders to be cancelled or changed.

But Parry said the system brings a new risk: There's a slight chance that there might not be a closing price for some securities if the bid-offer prices don't line up with demand at the end of the auction.

Jerome Favre | Bloomberg | Getty Images

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1