Recently, the Securities and Exchange Board of India (SEBI) has proposed a new mechanism to determine closing prices through closing auction session (CAS) in the equity cash market, starting with highly-liquid derivative stocks.
In a revised consultation paper on August 22, SEBI said the proposed CAS would be applied in a phased manner, beginning with stocks available in the derivatives segment — those with sufficient liquidity — and later extended to all stocks based on experience gained.
The proposal, if implemented, is expected to reduce volatility, improve fairness, and make it easier for large and passive investors to execute trades. SEBI consultation paper argued in its favour as against the current method, where the closing price is computed using a 30-minute volume-weighted average price (VWAP), between 3 and 3.30 pm.
Globally, most developed markets such as Nasdaq, NYSE, LSE, Euronext, Deutsche Börse, Singapore Stock Exchange and Hong Kong Stock Exchange have adopted closing auction for closing price long ago.
“As the closing price in India is determined by the last half an hour VWAP, it has been highlighted by some international passive fund houses that the current closing price mechanism can result in significant price volatility across a range of stocks, as well as high risk of large orders not being completed, which in turn adds to the tracking difference of a passive fund. The said issue is particularly significant during large event days, such as, index rebalancing days and derivative expiry day,” SEBI said.
A study carried out by SEBI on MSCI indices revealed that volatility during the last 30 minutes was significantly higher during the rebalancing days.
Execution plans
According to SEBI proposal, CAS would be divided into four phases — reference price calculation, order entry, random close, and final matching and market orders will get priority over limit orders. Any unexecuted limit orders from the continuous trading session will automatically move to CAS but cannot be modified, only cancelled.
To maintain orderly trading, CAS will operate within a 3 per cent up or down band of the reference price, determined using the VWAP of trades between 3 pm and 3.15 pm.
To enhance transparency, SEBI has proposed the dissemination of real-time data during CAS. This would include the indicative equilibrium price, cumulative buy and sell quantities, and imbalance data — both total and specific to market orders — helping participants make better-informed decisions.
With the introduction of CAS, the current post-closing session at exchanges would be discontinued
Are we ready?
No doubt, the the proposed mechanism ensures robust price discovery and enable institutional and large orders to transact with minimal market impact. When pre-market call auction was introduced in October 2010 by the exchanges, there were scepticism on its roll out and its efficiency on price discovery. So, from a technical perspective, it should not pose any challenge to market intermediaries.
Participants adopted it smoothly and the markets are functioning seamlessly. It has also arrested significant gap up or down during the opening session, unlike earlier days when the market used to swing wildly based on overnight global market triggers.
Given the significant retail participation in India compared to other developed markets, one has to wait and see how CAS arrests extreme volatility during the closing session, especially on index rebalancing and F&O settlement days. From that perspective, the roll-out of CAS in a phased manner, starting with derivative stocks, is a sensible move.
If the experiment shows no significant changes, SEBI should also be open to revert to the current VWAP mechanism, which is quite simple and integrates liquidity from all types of investors.