‘CAS is a move in the right direction, but the timing may not be right’

Why in the News

The Securities and Exchange Board of India (SEBI) has replaced the method used to fix closing prices on the stock exchanges with a Closing Auction Session (CAS), implemented at the start of this month. The earlier method took the volume weighted average price (VWAP), the average price of the last 30 minutes of trading, which a large order placed in the closing moments could tilt. The change follows the Jane Street episode, after which the regulator concluded that the earlier method could be moved in a participant’s favour. Traders hold that the direction of the change is right and the timing is not, since Indian markets carry far higher retail participation than the institution driven markets the mechanism was borrowed from.

How does the Closing Auction Session work?

1. Normal trading closes at 3.15 pm: Trading runs as usual until 3.15 pm, and all pending limit and market orders are carried forward into the CAS. Stop loss orders are removed from the system.
2. Reference prices are computed through the session: Exchanges calculate reference prices from 3.15 pm to 3.30 pm.
3. Order types narrow as the session runs: Market or limit orders may be placed between 3.20 pm and 3.25 pm (a market order executes at the prevailing price, a limit order executes only at the price stated by the trader). From 3.25 pm only limit orders are accepted.
4. The close is randomised: The session ends at a random time between 3.27 pm and 3.30 pm. Derivatives continue to trade until 3.40 pm.

Why did SEBI move away from the volume weighted average price method?

1. The weakness in an average: A large quantity traded in the closing moments moves the average, so the preceding 30 minutes count for little in the final price.
2. The trigger for the review: The regulator concluded after the Jane Street episode that the closing price under the earlier method could be tilted.
3. Global practice: Auction based closes are already used in developed markets, including the United States and the United Kingdom.
4. Institutional demand: Financial institutions and global players pitched the auction as the better mechanism for determining closing prices.

What does the auction change for participants?

1. Participation replaces dependence on a single print: The closing price is formed from orders placed in the auction rather than from a computed average, which makes price discovery more broad based.
2. Orders are no longer tied to the closing price: A participant can place an order at a higher or lower price according to their own requirement, instead of matching at whatever the closing price turns out to be.

Why are volumes in the session thin?

1. Participants are still adjusting: The session is new, and a change in market structure is first thought over and played out with caution before it is used.
2. The matching price is not visible: Price matching runs for five to seven minutes behind the scenes, so a participant does not know the price at which an order will match.
3. Part execution is the likely outcome: An order placed two per cent away from the market carries no certainty that the full quantity will be executed, and under executions are the more likely result.
4. The largest volume generators are absent: Arbitrage firms and proprietary trading firms are sitting out, since the session gives them neither the time nor the visibility to hedge in the futures and options (F&O) segment. They do not run unhedged positions.

Why is the timing of the change contested?

1. Market maturity: The Indian market is not yet mature enough for a mechanism designed for markets where participants have full information on when and how to participate.
2. Retail share is higher than in comparable markets: India has much higher retail participation than other major markets, which are institution driven, and retail awareness of the new session is still at an early stage.
3. A longer parallel run was possible: The session could have been run in simulation or in parallel with the earlier system for longer, giving participants time to get used to it before implementation.
4. Small orders may not find a match: Most retail investors trade in small ticket sizes, so a large institutional order placed in the session is unlikely to be matched.
5. Leverage pulls retail elsewhere: Retail traders prefer the derivatives segment over the auction because of the higher leverage available there.

Conclusion

The Closing Auction Session has been in force since the start of the month and is still evolving, which makes a comparison with the earlier method premature. Volumes remain low and the participants who generate most of them are staying out until they can hedge around the randomised close. The next test is whether participation broadens as the mechanism settles and awareness spreads at the retail level.

Matching Previous Year Question

“[2023] Consider the following markets : 1. Government Bond Market 2. Call Money Market 3. Treasury Bill Market 4. Stock Market How many of the above are included in capital markets? (a) Only one (b) Only two (c) Only three (d) All four ANSWER: (b)”