After just a month of teething troubles and protests, one of India’s biggest capital market reforms risks being watered down—if not entirely jettisoned. In early August, the Securities and Exchange Board of India (Sebi) directed bourses to discover end-of-day prices via a final 20-minute auction. This was meant to stop large traders from manipulating closing prices under cover of all-day continuous trading, known as ‘marking the close.’
It is also one of Sebi’s allegations against Jane Street. The Indian regulator froze some of this Wall Street firm’s index-option profits last year, alleging that they came from its distortion of underlying stock prices.
Jane Street denied the allegations as a fundamental misreading of its strategy and is pursuing an appeal before a tribunal. But apart from adopting a more aggressive stance against Wall Street heavyweights, what could Sebi do to make the cash market more honest? It rightly judged that policing alone wouldn’t suffice. Manipulation had to be nipped in the bud.
The stakes are high. For years, authorities have been alarmed by India’s rise as the world’s largest options trading venue. Pandemic boredom unleashed a wave of thrill-seeking behaviour among individual investors globally, aided by zero-brokerage apps and short-expiry derivatives. In India, such speculation continued after covid, with the notional volume of equity derivatives trading peaking at $6 trillion in February 2024.
With 90% of retail investors losing money trading derivatives, the craze was threatening to become a social menace, especially among younger men. As the wait for white-collar jobs kept getting longer, they had time—and access to ‘finfluencers’—to splurge on leveraged bets they couldn’t afford. While curbing retail speculation, the regulator began to probe if Big Whales were rigging the much smaller and less liquid cash-equity market.
Most global bourses discover closing prices by halting continuous trading and switching to an auction for the last few minutes. An equilibrium price where most orders can be matched is declared as final. Since any attempt to game an auction is quickly detected, Sebi moved about 200 derivative-linked stocks to a closing auction system. Then everything went haywire.
Intraday trends reversed abruptly in the 20-minute auction window. Option volatility exploded and local investors decried the system as unworkable.
Sebi lost its nerve. Over the weekend, it released a new consultation paper offering two options: either shorten the auction to minimize its impact or strip it from derivative settlement for at least a year and return to a 30-minute trading average. If Sebi chooses the second option, the market will largely go back to its old ways.
The regulator’s loss of faith in its reform is disappointing. Worse, the true villain isn’t getting enough attention. After all, if investors are behaving irrationally in the closing minutes, why aren’t arbitrageurs swooping in to enforce more orderly price discovery?
The simple answer is taxation. Securities transactions have been taxed by New Delhi since 2004, but rates have climbed to prohibitive levels. After the most recent increase, an arbitrageur who could stabilize prices by going long cash and short futures has no incentive to do so after paying a 0.05% tax on the total contract value.
This gives rise to a chicken-and-egg problem. As capital pools that could trade away inefficiencies stay away, the market becomes even shallower. Traders’ inability to execute large orders without moving prices further diminishes the profit potential from arbitrage. The finance ministry should have reworked its tax policies before Sebi adopted the auction method. A breakdown in fiscal-regulatory coordination is what doomed the reform.
Exorbitant taxation has other important side effects. Day traders dabbling in derivatives who would have otherwise remained profitable became net loss-makers after paying transaction costs—those accounted for over a third of their gross losses.
What are these costs? While broker commissions and exchange fees are falling, the securities transaction tax collected from retail investors has ballooned to ₹6,600 crore from ₹1,300 crore four years ago.
Sebi isn’t off the hook, though. A well-functioning market needs bullish and bearish views. But short sellers struggle to borrow stocks. That’s because Sebi—scarred by scams where bank money was used illicitly to fund speculative positions—tries to micromanage what should be a private transaction between lender and borrower.
All of this compounds the lack of liquidity. A market that resembles a small pond is getting in the way of both Big Whales and small fish. Reforms must boost depth. But after the latest botched attempt, it may be some time before the regulator can muster the confidence to try again. ©Bloomberg
The author is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia.