Call auction mechanism may cut volatility

The market regulator’s decision to introduce a pre-open session with a call auction mechanism is expected to reduce the quantum of volatility, typically visible in the first few minutes of a trading session. Experts believe the two Indian benchmark indices – Sensex and Nifty – would be able to avoid the sudden spurts sometimes seen when the stock markets open for trade.

The Securities and Exchange Board of India (Sebi) had said on Thursday a pre-open session with a call auction facility for the Sensex and Nifty stocks would be introduced on a pilot basis by both the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). While the date for the launch has not been announced, the stock exchanges have been directed to upgrade their systems to enable the launch.

A call auction, in simple terms, refers to a mechanism wherein buy and sell orders on all the selected stocks (in this case, Sensex and Nifty constituents) are collected over a fixed period of time and then processed in the auction. The price at which the highest number of orders is executed is chosen. In other words, the buy/sell orders are not executed immediately.

A call auction is different from the existing system of continuous order matching used by the Indian bourses. At present, a trade is executed if the buyer and seller agree on the price. This happens on an anonymous limit order book.

A 15-minute solution
According to the Sebi circular, the pre-open call auction session will be for 15 minutes between 9 am and 9.15 am. While the first eight minutes will be reserved for order entry, modification and cancellation, the next four minutes will be kept for order matching and trade confirmation. The remaining three minutes will be the buffer period to facilitate the transition from pre-open session to the normal market.

“The mechanism will reduce the high volatility that is the main concern during the initial hour of trading sessions in domestic markets,” says Susan Thomas of Indira Gandhi Institute of Development Research (IGIDR). She recently published a research paper titled, “Call auction: A solution to some difficulties in Indian Finance”.

According to her paper: “Call auction can improve the functioning of the market on such issues as market opening, market closing, extreme news events and potentially for illiquid securities, including bonds. They can usefully replace some existing market rules like circuit breakers. At the same time, there are many subtle elements in making a call auction market work, which require care in market design.”

Some downside, too
Call auctions, however, have their share of criticisms, too, with the most common being that of latency, or the lag effect. This is because, under the call auction mechanism, markets tend to react slowly to news as the orders are not immediately executed. Also, chances of players forming a cartel to take the stock in a particular direction are greater.

But, according to Thomas, the greatest benefit of continuous trading is the immediacy of liquidity. “For a large fraction of listed stocks, the liquidity is too sparse to justify the need for continuous access to liquidity. A call auction that consolidates orders over a period of time and results in a trade at a predetermined time naturally recommends itself as the alternative trading mechanism,” she explains.

Sebi, incidentally, is trying the framework only on the most liquid stocks, where participation is highest and it is difficult for few players to manipulate. Call auctions are used by some stock exchanges to fix opening or closing prices — trading starts or ends with a call auction. Their use as a main trading mechanism is now rare.