Improved closing auction

Sebi should aim to increase participation

It has been 10 weeks since the Securities and Exchange Board of India (Sebi) changed the way the stock markets end their trading day. It introduced the closing auction session (CAS) on August 3, with the idea of giving one efficient price for index funds, large institutional investors, and derivatives traders. But, instead, it led to problems — especially for derivatives traders, who decided to stay out of the market because of the unpredictability and volatility during the end session. A new circular dated October 15 addresses the issues and is in the right direction. It has delinked derivatives from the CAS close. The notional average daily derivatives turnover is more than 200 times that in cash. Retail investors account for about 40 per cent of the turnover in index options. The CAS was putting all these traders out of the system. The problems should be fixed in December.

 

The issue started when the indicative equilibrium prices in the CAS system fluctuated wildly as algo traders entered and cancelled orders, which led to volatility. The CAS settlement price is directly tied to expiring derivatives contracts, where traders had limited visibility of how the market would move. Thus, most derivatives traders and domestic funds stayed away from the market during the auction window. The bigger issue was that cash trading stopped at 3.15 pm while derivatives traded till 3.40 pm. The final value for the benchmark indices that came after the CAS was many a time far away from the closing price at 3.15 pm. Likewise for stocks that are part of the derivatives, or futures & options (F&O), segment.

 

The volumes handled in the auction are about 1 per cent of the daily cash turnover. The auction filled well on days when indices were rebalanced. For example, on the day of MSCI rebalance there were many buyers and sellers in the auction session and volumes were at 22 per cent of the entire trading day. But in normal days it lacked participants and sufficient volumes. In comparison, on the New York Stock Exchange, the CAS handles 12.43 per cent of daily volumes, and the same is 10 per cent for the Nasdaq. In such markets, it is hard for any single player to move the closing price because the CAS accounts for more than 10 per cent of the volumes. In India, the volumes are only 1 per cent and a small player can move stocks and thereby the index in the auction session and make money out of derivatives trades.

 

The new circular addresses most of these issues. From December 7, the expiry session goes back to the previous 25-year-old system of volume weighted average price (VWAP) while the daily closing price of underlying stocks will continue to be determined via CAS. Expiring index derivatives will stop trading at 3.30 pm or the same time as the cash markets. The auction will happen afterwards (3.30-3.40 pm) but stock derivatives will continue to trade until 3.45 pm.

 

This is a return to the old system but the auction stays and sets the official closing prices. But the link between derivatives and VWAP is restored. However, Sebi is yet to address how to bring in more passive funds to participate, improve the securities lending and borrowing mechanism (SLBM) or short selling, or separate auction order types that exist in the developed markets. A working stock-lending and short-selling market would let traders sell borrowed shares in an auction where buyers are bigger in numbers, narrowing the imbalances at the close. Thus, there is more to be done. Most importantly, fix stock lending and deepen the auction pool.