New Closing Auction Needs Tweaks As Price Dislocations Emerge, Says Former SEBI Member

India's new closing auction for stocks eligible for futures and options needs tweaks after its first few sessions showed prices moving beyond the 3:15 p.m. level and those indicated by the derivatives market, according to former Securities and Exchange Board of India whole-time member Ananth Narayan.

Narayan said lower volumes in the Closing Auction Session, or CAS, were not his primary concern. He instead flagged price movements during the auction and said SEBI and market participants would need to examine what was preventing greater participation.

"I'm not so bothered about the lower volumes per se, but the fact that your prices seem to move beyond what it was at 3:15, and beyond what is indicated in the open derivative markets, that is definitely a matter of concern," Narayan told NDTV Profit.

Narayan backed the design of the closing auction but said its first few days had shown that changes were required.

"I think it's the right design, but while I think SEBI and the market participants tried to prepare for this, clearly the first few days tell us that there are some tweaks required or some changes required," he said.

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Price Signals

Narayan said two pieces of information were not readily available on certain broker platforms: the indicative price at which the auction would clear at a particular point and the order mismatch for the stock.

He said both were important for market participants during the auction. The indicative price would provide the derivatives market with an anchor, while information on the order mismatch would help participants identify when the indicative auction price had moved away from what they considered fair value.

"The moment you see aberrations, jump in," Narayan said, explaining how greater participation could help remove such price differences.

Narayan said SEBI's circular had made clear that this information should remain available. He said technology changes may be needed to make the information readily available to market participants.

He also said larger institutional participants, including mutual funds, could watch the auction and step in when they see the price of a stock moving away from the level indicated by futures or what they consider fair value.

Retail participation could take time to develop as investors become familiar with the closing auction, he said.

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Market Imbalance

The gap between activity in India's cash and derivatives markets existed before the closing auction was introduced, Narayan said.

He said the difference was also present under the earlier volume-weighted average price mechanism. Recalling analysis from around the time he left SEBI, Narayan said index-options volumes on expiry days, measured in cash-equivalent terms, were about 700 to 800 times the underlying cash-market volume.

"The volumes that we were seeing in the index option market on expiry day in cash-equivalent terms was 700 to 800 times the underlying volume in the cash market," he said.

Narayan described the mismatch as a matter of concern that the market needs to examine.

He also pointed to another feature of India's derivatives market: participants often carry open positions into expiry. Globally, he said, most derivatives contracts are either closed or rolled over before expiry.

"I would frankly be happier if this imbalance was addressed a little bit and more people close positions earlier rather than wait till expiry," Narayan said.

Narayan also clarified that short selling is not prohibited in India and that the stock lending and borrowing mechanism, or SLBM, is available.

He said the mechanism was not widely used because market participants seeking to short stocks could instead use the derivatives market, which was more liquid and offered leverage.

Narayan said he hoped the introduction of the closing auction would increase the use of SLBM and help increase cash-market volumes. Narayan said he had been told that SEBI was working on improving the SLBM mechanism.

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Auction Rationale

The closing auction took effect on Aug. 3 for F&O-eligible shares. Continuous cash-market trading in these stocks ends at 3:15 p.m., after which they enter the closing auction process until 3:35 p.m.

Orders placed during the auction are pooled and matched, with the resulting equilibrium price becoming the official closing price for the eligible stock.

Stock and index derivatives now trade until 3:40 p.m., compared with the previous 3:30 p.m. close. Shares outside the F&O segment continue regular cash-market trading until 3:30 p.m.

Narayan said SEBI considered the closing auction after consultations and studying practices in other markets.

Global passive funds, which Narayan said account for about 30% of foreign portfolio investor assets under management in India, as well as global active funds, had sought such a mechanism because of issues including tracking errors, he said.

Narayan also said index providers assess markets on several market-structure parameters, including the availability of a closing auction. India's absence of such a mechanism had resulted in it being classified as restricted on that parameter, which Narayan said had weighed to a small extent on the weight assigned to India.

Another consideration was activity in the cash market on index-rebalancing and derivatives-expiry days, when some price movements had raised questions among market participants, Narayan said.

He said SEBI had examined other jurisdictions before introducing the mechanism, while existing literature suggested closing auctions could improve trust in closing-price discovery and reduce volatility. He also said experience in other markets showed that implementation could be difficult.

Narayan said the design of India's closing auction remained sound, but the experience of its first few sessions showed that SEBI and market participants would need to examine changes that could increase participation and prevent price aberrations.

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