Summary:
SEBI says initial liquidity concerns around India’s Closing Auction Session are part of the transition to auction-based closing mechanisms. The regulator is monitoring CAS performance and reviewing derivatives settlement methodology amid concerns over expiry-day volatility and price discovery.
The Closing Auction Session (CAS), integrated into India's equity market from August 3, has attracted investor discourse about liquidity, price discovery, and ramifications for closing prices. SEBI Chairman Tuhin Kanta Pandey remarked that such issues were inevitable and were witnessed globally in exchanges that evolved auction-based closing sessions.
The newly implemented CAS framework intends to enhance price discovery mechanism for eligible stocks with derivative contracts as opposed to the VWAP closing mechanism. Herein, buy and sell orders are matched to establish an auction price during the closing hour.
SEBI assured that they will keep the framework in place as the markets evolve. In fact, the concept of closing auction is followed in the US, Japan, Hong Kong, and other exchanges albeit with initial liquidity issues.
Why Concern About Liquidity During The CAS?
A lot of market participants have been worried that lack of sufficient liquidity during the auction period that determines closing price on expiry days will lead to a price swing.
This concern was justified since India's equity market has a massive derivatives market with daily notional volumes that dwarfs cash segments.
Such volatility risk would be accentuated in a case where cash segment liquidity during the auction period does not suffice to meet obligations in the derivatives market.
This situation led to huge volatility on the Sensex on September 3 where during the closing session the index plummeted almost 2100 points before recovering some ground to close at 76,152.86, down 417 points from the previous close. This development has made critics question the efficacy of the auction system.
SEBI Examines Derivatives Settlement Methodology For Possible Tweaks
In addition to CAS framework review, the regulator is also examining the set of instructions for determining settlement price of futures contracts on expiry days.
In this regard, SEBI seeks industry feedback before finalizing any recommendations. As a matter of fact, the CAS was implemented following concerns about huge swings during expiry days of futures contracts on key indices.
While the regulator acknowledges the efficacy of the current VWAP methodology, it is considering options to ensure efficiency of the settlement price discovery mechanism.
It should also be noted that SEBI and the stock exchanges will keep the CAS framework in place while observing its efficacy. In other words, they can consider a full exit if it does not pan out as envisioned within a reasonable time.
Market Impact Of The CAS Implementation
The implementation of the CAS has been a worry for investors on the premise that it has the potential to increase volatility during the closing period of the trading session. They are yet to observe whether changes in trading patterns and increase in participation will improve liquidity during the auction period.
From the regulator's standpoint, the framework is efficient and was tested during the MSCI rebalancing exercise. Therefore, there is no reason to believe that it will not work provided there are enough buyers and sellers to meet the huge notional volumes.
However, its impact will be significant on the overall market functioning once the regulator finalizes the recommended tweaks to the settlement price discovery methodology of derivative contracts.
