Sebi Likely to Suspend Closing Auction Session Mechanism for Derivatives Settlement, Revert to VWAP for a Year

India's markets regulator, Securities Exchange Board of India is likely to partially stop the use of Closing Auction Session (CAS) mechanism. According to a report by news agency Reuters which cited sources privy to the matter, the use of the mechanism is likely to be suspended for computing derivatives settlement prices for at least a year.

The reported development indicates that a partial rollback of the newly implemented mechanisms is set to take place on D-street following feedback from industry stakeholders and other market participants.

Why Is CAS Likely To Be Suspended

Earlier this year, the CAS mechanism was implemented by Sebi on August 3. The mechanism was implemented to determine closing prices of stocks that have associated futures and options contracts. 

Under the CAS mechanism an auction at the end of the trading day pools all buy and sell orders to determine a single official equilibrium closing price, replacing the continuous trading process which determined closing prices before August 3.

However, the system is reportedly being replaced for the derivatives settlement for a while, because the new process triggered extreme volatility and abrupt price swings, particularly on expiry days. On expiry days when the liquidity is thin or large hedging orders arrive all at once, cash settled index options that are marked to that single auction price have witnessed massive jumps in several instances over the last two months.

For instance, recent expiry days saw indicative index prices plunge by over two per cent in the auction window alone before recovering. The markets regulator acknowledged the significant market reaction in a post on the social media platform X.

Sebi said in its post that it had received around 20,000 comments regarding its proposed changes to the framework. Additionally, in its September review plans, the regulator proposed to stop publishing the indicative value of an index during the 10 minute CAS window. Instead, it planned to publish only the indicative prices of individual stocks, arguing that the final index value was still being determined and could be misinterpreted by market participants.

Market feedback pushed back against this approach. Participants stated that sophisticated trading desks could try to reconstruct those index values independently, meaning that removing the indicative index figures would reduce market transparency without actually addressing the core manipulation concerns. Furthermore, the feedback favoured keeping the existing timeline intact to better facilitate true price discovery and properly align derivatives trading with the cash market closing process.

What Happens Now

As the closing auction mechanism is reportedly being paused for derivatives settlement, the market will revert to its older methodology. According to the report, the settlement price for derivative contracts will now be calculated using the volume weighted average price (VWAP) of trades executed during the final 30 minutes of regular continuous trading.

This means the final settlement calculation will once again rely on a broader half hour window rather than the outcome of an end of day auction. Returning to the VWAP mechanism even if temporarily is expected to mitigate the sudden price distortions seen near close to the last minutes of the session especially on expiry days.

While the new closing auction rules will reportedly not be used from the settlement of index and stock derivatives, the closing auction will still be retained to determine the end of day prices for underlying stocks in the less liquid cash market. The changes are expected to take effect by the end of October.