Short of expectations: New closing auction system on exchanges needs review

The new closing auction session has triggered price divergences in F&O stocks, raising concerns over liquidity, price discovery and its impact on investors

The “closing auction session” (CAS) mechanism, meant to be a better closing price-discovery system for eligible derivatives stocks than the older system of volume-weighted average price (VWAP), has fallen short of the benefits it was hoped to deliver. At least, that is the experience thus far. Even though some market watchers argue that it is too early to conclude, there is little doubt that the CAS has left many market participants puzzled. Started on August 3 by both the BSE and the National Stock Exchange, the initial response to the CAS also suggests that merely following globally recognised systems may not always be a good proposition unless they factor in Indian conditions. 

The CAS is an auction-based mechanism to arrive at a fair closing price for stocks eligible for futures & options (F&O) trading. Its introduction was also aimed to benefit passive funds and other institutional investors. Prices are based on bids by market participants during a special 20-minute trading window (from 3:15 pm to 3:35 pm). This special window starts after the closing of the cash-market segment for these stocks at 3:15 pm. Introduced by the market regulator, the Securities and Exchange Board of India, the CAS replaced a nearly 26-year-old system in which the last 30 minutes of continuous trades were considered to arrive at the closing price of a stock based on the VWAP. Nothing has changed for securities outside the CAS — their closing-price discovery remains under the VWAP mechanism. The key reason Indian markets shifted from the last traded price (LTP) system to the VWAP was that the LTP was vulnerable to end-of-day price manipulation, wherein even a small transaction in the last few seconds could skew the official closing price of a stock. 

In the CAS, at the end of the auction, the buyer and seller interests are matched. The price at which the maximum volume is executable becomes the closing price. The results are there to see. While individual stocks have seen sharp moves after trading at the cash market ends at 3.15 pm and the CAS starts for F&O-eligible stocks, it has affected the closing value of the Nifty 50, which has been visibly different than the closing value of the BSE Sensex on each of these days. Sharp price differences between exchanges for frontline stocks are creating unnecessary price asymmetries. Some market participants have argued that for systems like the CAS to deliver the desired results, it is essential that the ecosystem is diverse and large, with participants across the spectrum providing sufficient liquidity. For the CAS to succeed in India, it will require wide and regular participation from institutional investors such as domestic mutual funds, insurance companies, pension funds, family offices, sovereign wealth funds, foreign investors, along with high-networth individuals, arbitrageurs, market makers, and the like. Wide participation along with high liquidity will help minimise price diversions across exchanges and market segments. Thus, it is possible that the system will stabilise in the coming days. 

However, if the CAS is unable to deliver the desired results despite its global acceptability, the regulator and stock exchanges must not shy away from acknowledging the shortcomings, and take appropriate corrective action. It is possible that the Indian market is not yet prepared for the transition and the idea can be revisited after a reasonable gap. It is important to ensure that the legitimate interests of market participants are not compromised. Volatility in closing prices of F&O stocks has meant that investors, including those who purchased mutual-fund equity schemes owning these F&O stocks on or after August 3, have taken some hit or gained at the cost of others because of market anomalies. Such outcomes have an impact on real-money transactions. Friction and uncertainty in price discovery are not desirable in the stock market.