After the swiftly implemented Closing Auction Session (CAS) thinned volumes and faced industry pushback, the Securities and Exchange Board of India (SEBI) last week finally announced that it may propose changes to the settlement method for the derivatives segment.
“Among the issues raised, a significant area of feedback relates to the determination of settlement prices of derivative contracts on expiry based on the closing price determined through CAS,” the markets regulator noted in its press release on Thursday.
Consequently, the regulator “may be proposing certain changes in the methodology for determination of settlement prices of derivative contracts for which a consultation paper will be issued in about a week,” it added.
Root cause of the issue
Currently, trading in the CAS ends at 3:30 PM, while trading in the derivatives segment extends for 10 more minutes. This mismatch in the end times of the sessions is among the biggest causes of concern for the trading industry.
Institutional investors — which include corporates, foreign investors, mutual funds, and proprietary traders with complex algorithms — together account for around 60-65% of the turnover in the derivatives market.
Derivatives are financial instruments that allow traders to buy or sell an underlying security at a predetermined date and price in the future. These institutional investors, who have a wide range of bets spread across the market, use derivatives to either hedge their bets or look for arbitrage opportunities. In fact, hedging is essential for such traders due to the vast amounts of money they handle on a daily basis.
For example, if a trader owns a significant amount of a stock in the cash market, which is the regular trading session from 9:15 AM to 3:30 PM, then the trader will often sell the stock in the derivatives market to hedge their risks and protect capital, irrespective of whichever way the price moves. The vice-versa can also be true when the trader first sells a stock in the derivatives market and then buys it in the cash market.
Earlier, when the cash and derivatives markets ended at the same time, traders had price visibility and minimal uncertainty while planning such hedges. However, with the advent of CAS and the extended derivatives session, traders cannot safely predict what may happen in the derivatives market once the CAS ends.
Other issues such as time pressure during the CAS and limited price visibility have also compounded this problem, leading most institutional traders to sit out of both the CAS and derivatives segments to avoid the risk.
This risk is even higher on days when the derivatives contracts of the Nifty 50 and Sensex expire — a time when every trader is desperately trying to maximise their profits or minimise their losses ahead of the payday.
As the big players sit out of the CAS, the thin volumes lead to high volatility, with a handful of big orders capable of significantly swaying prices. This volatility in the CAS, in turn, leads to volatility in derivatives, which are linked to CAS-determined prices of underlying securities. Thus, the bigger players are avoiding both for now.
The data also shows the same. The National Stock Exchange’s (NSE) total turnover in the derivatives segment for August was Rs 34.48 lakh crore — lowest since November 2023.
“Average daily options turnover (of NSE) also fell by 20% month-on-month in August. Therefore, the 18-20% decline should be viewed as the overall market-volume impact observed after CAS was introduced, rather than a measure of the volume decline specifically within the CAS window,” said Shweta Rajani, head of mutual funds at Anand Rathi Wealth.
Will aligning F&O and CAS help?
Market participants thus want the derivatives and CAS session ends to be aligned, and the settlement prices of derivative contracts to be de-linked from the settlement prices in the CAS, particularly on expiry days.
If the regulator does so, it will not solve the caution and the lukewarm response to the CAS overnight. However, what it might do is cut down a significant part of the uncertainty in traders’ minds.
Institutional traders do not like to trade without proper hedges, and an aligned closure of both sessions and de-linking of CAS and derivatives prices may provide a vital hedging avenue for such traders, pumping much-needed liquidity into the CAS. This will lead to better price discovery and reduce volatility during CAS, which would make the derivatives segment more stable.
“Such a measure may reduce hedging risks and stuff out some of the uncertainty but may not be enough by itself to normalise volumes to pre-CAS levels. People and algos will need more time to adapt and come up with newer strategies,” a derivatives analyst at a domestic broking firm said.
On expiry days, experts suggest derivatives settlement prices could be based on the traditional volume-weighted average price (VWAP) method, which the CAS had replaced. “This could reduce the possibility of extreme price volatility while still allowing sufficient price discovery,” according to Rajani.
While SEBI has indicated its unwillingness to bring back the VWAP system in any form so far, we’ll have to wait and watch for the regulator’s consultation paper sometime this week to know more.
SEBI Bhavan in Mumbai (Wikimedia Commons) 
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