The Securities and Exchange Board of India (SEBI) could consider changes to the way derivatives are settled under the new closing auction session (CAS), including using a VWAP-based settlement price and tightening price bands, according to market sources.
The concern is particularly acute on expiry days, when option traders need to hedge their positions against the underlying market. A sharp movement in the auction-determined price can lead to large swings in option premiums.
Settlement revamp
The regulator could consider reverting to a volume-weighted average price (VWAP) for settling index derivatives on expiry days, rather than relying entirely on the closing price discovered through the auction.
Market participants also expect SEBI to examine the price band for the auction and the timing of cash and derivatives trading. Another suggestion is to align the expiry of index derivatives more closely with the cash-market session, reducing the gap during which traders cannot hedge their positions against the final cash-market price.
The timing gap means option writers cannot hedge against a closing price that is yet to be determined, said HDFC Securities. Thin participation in the auction can further reduce predictability, keeping option writers on the sidelines.
CAS concerns
The changes are aimed at addressing concerns that have emerged since CAS was introduced on August 3. The mechanism ends continuous cash-market trading at 3.15 pm, while index derivatives continue to trade until 3.30 pm. The auction then determines the closing price used for settlement.
Market participants have also suggested retaining CAS for determining the cash-market closing price while using a separate VWAP-based price for derivatives settlement. Other proposals include tighter price bands and restrictions on late order entry into the auction.
“Plausible fixes, none of which require rolling CAS back,” include tighter auction price bands, an extended or overlapping derivatives session and VWAP-based settlement spanning the pre-auction and auction windows, HDFC Securities said.
The impact has been visible in derivatives activity, with options premium average daily turnover falling 19 per cent month-on-month to about ₹61,000 crore in August, while BSE’s options premium turnover was down 26 per cent to about ₹18,700 crore.
Cash-market activity, however, remained stable, suggesting that the disruption has been concentrated in derivatives and particularly around expiry days.
SEBI had said last week that it would review the methodology for determining settlement prices of derivative contracts following feedback on CAS. It is expected to issue a consultation paper on the proposed changes soon.