The Securities and Exchange Board of India (Sebi) on Saturday proposed changes to how derivative contracts are settled on expiry days, and operational rules for the closing auction session (CAS) after a rocky start to the month-old system.
The framework for F&O stocks, introduced on 3 August, had led to unexpected price swings and market uncertainty, prompting the market regulator to propose tweaks.
Mint explains the latest proposals and what they mean for the markets.
What changes has Sebi proposed to F&O settlement?
The market regulator has proposed two options for determining the settlement price of index and single-stock derivatives on expiry days.
The first is a Blended VWAP (Volume Weighted Average Price). Under this approach, the settlement price would be based on trades executed during the last 30 minutes of continuous trading (CTS) as well as the 10-minute CAS. The contribution of each period would depend on the actual traded value during that period. There would be no fixed or predetermined weight for CAS or CTS.
For example, if 90% of the total traded value comes from the last 30 minutes of CTS and 10% from CAS, the two periods would contribute in that proportion to the settlement price.
VWAP is the average price at which a security trades over a period, weighted by the volume traded at each price. It was the framework used for determining closing prices before CAS was introduced.
The second option is that the settlement price would initially continue to be based only on trades during the last 30 minutes of CTS. CAS trades would not be included in the settlement calculation during this interim period.
Sebi said the long-term intention under this option would still be to move to the blended methodology, but only after at least one year, subject to sufficient liquidity, participation and familiarity with CAS.
Why were the changes needed?
Derivatives trading remains active near the end of the trading day, including during the underlying stocks' auction process. This is important on expiry days, when activity in expiring index options can be concentrated near the close.
Sebi's data shows that derivatives activity remained significant during CAS. Between 3:20pm and 3:30pm, the average premium traded per minute was ₹189.82 crore on NSE and ₹288.94 crore on BSE. These figures were higher than the average for 3pm-3:30pm before CAS.
Another issue is the indicative equilibrium price (IEP). Unlike an executed price in continuous trading, an IEP is an evolving price based on orders in the auction book. It can change as orders are added, modified or cancelled. It does not mean that trades have actually taken place at that price.
Sebi said market participants have been using this indicative information while trading derivatives. This has raised concerns because the underlying price discovery is still taking place when those derivatives trades are being executed.
What does a change in market hours mean?
Sebi has proposed two alternatives. Under Option A, continuous trading in all stocks would continue until 3:30pm. CAS for eligible F&O stocks would then run from 3:30 pm to 3:40pm, after a one-minute transition period. Derivatives trading would continue until 3:45pm, giving traders five minutes after CAS ends.
Currently, transition to CAS begins at 3:15pm while the actual CAS window runs from 3:20pm to 3:30pm. While the cash markets close with CAS, derivatives trading is allowed until 3:45pm. The timing of the derivatives market post-CAS would shrink if the proposals come into effect.
Under Option B, the current 3:15pm cut-off for CTS in CAS stocks would remain. CAS would run from 3:15pm to 3:25pm, including a one-minute transition, and derivatives trading would end at 3:30pm.
Sebi is also proposing to reduce the transition period between CTS and CAS from five minutes to up to one minute. The aim is to make the shift from continuous trading to auction-based price discovery smoother and increase the CTS period by about four minutes.
The market regulator said that once the underlying’s closing price is discovered, there is limited need to continue trading expiring contracts, though a short window may still be needed to manage or reverse positions.
How would trades be affected?
The biggest impact would be on trades and prices around the market close, particularly on expiry days. The move is expected to bring back liquidity to the indices, which was stripped off due to CAS.
Sebi has also proposed to stop disseminating the IEP-derived Indicative Index Value (IIV) during CAS. Individual securities would continue to have their IEPs displayed. Sebi's concern is that the IIV can be mistaken for an actual index level even though it is based on evolving, unexecuted indicative prices.
If the proposals come to action, traders would be able to cancel orders placed within 1% of the reference price during the CAS, while orders beyond 1% and up to the existing 3% band would not be eligible for cancellation. Such orders can only be modified to improve the price, helping keep the auction order book more stable and credible.
“Our discussions with domestic prop traders indicate the return to VWAP-based derivative settlement price along with inability to cancel limit orders placed beyond +/-1% threshold should reduce end of period volatility on expiry days,” said a Jeffries report from 14 September.
Sebi wants to distinguish between orders based on how close they are to the reference price. Orders within 1% plus or minus would have more flexibility, while those 1-3% away would face tighter cancellation rules. The proposal could reduce the chances of withdrawal of trading interest at prices that are far away from the reference price while also improving stability and credibility of the auction book.