The stock market regulator may look to bring back the old mechanism to settle derivative contracts on expiry days, two people aware of the discussions said, in a partial revision to the closing auction session (CAS) introduced a month ago. The goal is to smooth out last-minute swings on settlement days, which open up gaps between the Nifty and Sensex.
The Securities and Exchange Board of India (Sebi) on Thursday said it will review the settlement process after receiving market feedback and said it may issue a consultation paper on the matter within a week. According to the people cited above, while the daily CAS will continue as before, Sebi may propose settling weekly and monthly derivatives using the previous volume-weighted average price (VWAP) model, or using a combination of VWAP and CAS prices.
"Nifty and Sensex options, which expire on a weekly and monthly basis, can be settled at a 15- or 30-minute VWAP, but the tricky issue is the settlement of stock futures and options, which expire on a monthly basis. The regulator could use a combination of CAS and VWAP to settle the relevant stocks which are also index constituents," one of the two people mentioned above said on the condition of anonymity.
Distortion
Derivatives contracts are settled every Tuesday on the National Stock Exchange and every Thursday on the BSE. Before CAS debuted on 3 August, stock and index derivatives were settled using VWAP—average price an asset has traded at, weighted by how much volume traded at each price—during the last 30 minutes of trading.
However, since CAS was introduced for 213 stocks eligible for derivatives trading, settlement occurred at prices discovered in thinly traded auctions held at 3:15-3:30 pm. Essentially, options contracts with premium value in tens of thousands of crores of rupees were settled based on prices reached in a thinly traded auction of ₹1,200-1,300 crore between NSE and BSE.
A Sebi official was not immediately available for comment.
"By distorting the index stock prices during the auction on settlement days, the index options positions taken prior to the auction could swing wildly, causing a divergence between the values of the Nifty and Sensex," the second person said. "Reverting to the VWAP mechanism would obviate price distortions on settlement days while the existing practice can continue on non-settlement days."
The Sebi board meeting on 24 September may discuss public feedback on the consultation paper, the first person added.
The price of a derivative is simply the expected spot price on a future date. Based on supply and demand, derivatives normally trade at a premium to spot prices. However, the derivatives price converges with the spot rate at expiry or settlement, when the spread between the two disappears.
Arbitrage gap
With the introduction of CAS, the continuous trading session (CTS) for eligible cash stocks closes at 3:15 pm, while derivatives trading in these 213 stocks continues until 3.40pm. Under CAS, orders can be placed between 3:20 pm and 3:30 pm, with closing prices discovered based on maximum bids and offers between 3:28 pm and 3:30 pm. These prices, from which derivatives would take cues, are released at 3:35 pm and used for the settlement of derivatives at 3:40 pm.
On settlement days of Sensex or Nifty, there would be a divergence between the two indices when relatively thinly traded CAS prices are used in large-value derivatives settlements.
A key reason for the divergence between indices under CAS is the low presence of arbitrage traders and funds and retail investors. Arbitrageurs step in to buy the cheaper stock in one exchange and sell it at a higher price on the other, or exploit price differences between spot stocks and their derivatives, profiting from the gap narrowing while smoothing out price differences.
These traders execute both buying and selling simultaneously, but under CAS, the final price is known only at 3:35 pm, preventing such arbitrage trades. Retail investors, meanwhile, often place limit orders outside the 3% upper or lower band for CAS stocks, based on their reference rates determined at 3:15 pm. This leaves the short 20-minute window dominated by thin, institutional orders (passive funds), and prone to divergences between stocks and indices on the two exchanges.