When the most mature market, the US, moved to the T+1 settlement process in May 2024, India had already been operating under this settlement cycle for nearly 18 months. This transition was implemented in a phased manner. Nearly two years later, many markets have adopted or transitioned to T+1, including Pakistan, which moved to T+1 in February this year.
Market transitions are long-drawn, and at times volatile and cumbersome, but that is how markets advance and upgrade themselves. This is also because a lot depends on human intervention, which is now steadily dwindling as technology takes centre stage.
Resistance and pushback in past
I remember when Badla was removed and exchange-based derivatives were introduced. There was considerable resistance and critical feedback at the time. But it was the need of the hour. When settlement cycles moved from T+3 to T+2 and then to T+1, there was again resistance and pushback, particularly from foreign investors with respect to the short time available for pre-funding approvals. The moot point is that systems were tweaked and technology was used to accommodate these changes and implement systemic reforms.
As a market observer, one of the biggest issues with the new system is the lack of information available during the session.
What’s in there under Closing Auction Session?
To be sure, the Closing Auction Session begins at 3:15 pm with the calculation of the reference price and culminates in the establishment of the equilibrium price by the end of the session at 3:30 pm. In the process, the exchange progressively narrows the liquidity funnel every five minutes, eventually allowing the serious players to determine the equilibrium price.
Until continuous trading ends, all trades and strategies are allowed. At 3:15 pm, only open orders, market orders and limit orders are allowed to move into the CAS, with a price band of +/-3% of the reference price. At 3:20 pm, the funnel narrows further, with market orders removed and only limit orders allowed. At 3:25 pm, the session stops accepting limit orders and moves into the random closing phase.
The timing of the random close depends on the liquidity pool available at that point. Once orders are matched at the equilibrium price, the exchange announces the equilibrium price, which becomes the settlement price for the day.
There are a few aspects that need consideration. One argument is that the trading turnover during the CAS could be only a fraction of the normal turnover seen in the last 15 minutes of continuous trading.
In the first week of CAS, average daily turnover was Rs 1.26 lakh crore. Even after excluding around Rs 1,200 crore of average traded value, the overall turnover suggests that the market is adjusting to the new CAS regime. Investors appear to be completing their trading activity before 3:15 pm in the cash market, leaving delivery-based investors — both retail and institutional — to participate in the CAS and establish the closing price.
To put this in perspective, nearly 29% of total shares traded are delivered, with FPIs and mutual funds accounting for a significant share of delivery-based activity. This means the CAS automatically excludes nearly 70% of the normal market liquidity pool.
It should be noted that, unlike developed markets where institutions account for a larger share of daily turnover, India’s market has a significantly higher participation from traders and other non-delivery-based participants.
Therefore, even if the objective is to limit speculation around the settlement price of stocks and indices, the price band could perhaps be made dynamic and linked to the reference price. There is also a case for reducing the current price band, particularly since the data available with the regulator suggests that price band movements in the last 15 minutes are generally not significant.
Why not consider a dynamic price band?
Another issue is information transparency. The exchanges display the imbalance quantity during the session, but they do not show the depth of the session — for instance, the accepted volume or traded quantity at different prices at the equilibrium price on a real-time basis.
Perhaps this depth should also be displayed. It would provide market participants with a better understanding of liquidity during the session and allow F&O traders to assess price movements and take corrective action during the last 10 minutes.
After five days of CAS, the options market appears to be aligning itself with the cash market. While that is a positive sign, there needs to be greater emphasis on short selling and the securities lending and borrowing mechanism to deepen liquidity during the session.
The market regulator is already working on a draft framework, following consultations with stakeholders, to enhance the Securities Lending and Borrowing Mechanism (SLBM). A vibrant SLBM framework led by long-only funds, mutual funds, insurance companies and pension funds could help bring the desired depth and liquidity to the CAS.
Some may ask how this is linked to CAS. The answer is that as traded value increases, the cost of margin financing also rises for the investor. Volatility during the last 15 minutes of trading could increase or decrease traded values and, consequently, the cost of financing.
Margin trading is typically a leveraged, longer-duration position, with the book often increasing when markets fall and unwinding as markets rise. There need to be adequate guardrails to safeguard this segment, particularly as the MTF book is now close to $15 billion.
Excessive volatility during the last 30 minutes could trigger a steep sell-off, which could then spill over into the CAS, resulting in sharp deviations in closing prices and additional volatility in the derivatives market. With the options market remaining open for an additional 10 minutes, this volatility could become particularly sharp and potentially increase risks for retail investors.
The CAS framework has been implemented after nearly two years of consultations and two iterations of the framework. It is now important to enhance the framework further and bring the various market segments into sync to create a more robust and integrated market structure.
There should be no going back. It is onwards and forward.
