Stock markets globally have multiple layers of stakeholders, all of them invested in signals transmitted by trading patterns. The constituents directly concerned with price movements of individual stocks and their impact on various indices are actual investors—both institutional and retail—as well as the two-layered regulatory structure comprising exchange management and the jurisdiction’s market regulator.
A recent move by the Securities and Exchange Board of India (Sebi) to improve how the Indian market functions has resulted in avoidable volatility; this week’s spasms may be short-lived, but could extract long-term costs.
A Sebi-directed change in how each day’s closing prices of cash-market stocks are calculated—from the earlier method of volume-weighted average prices of trades done in the last 30 minutes of trading to a ‘closing auction session’—has unwittingly sparked a confrontation between two key segments.
While foreign portfolio investors (FPIs) welcomed the switch, saying it aligns with global best practices, domestic institutions have opposed it on the argument that India’s market lacks the deep liquidity needed for an auction to determine prices. This was evident at the close of Tuesday’s trading.
Retail investors, unfortunately, have been caught in the crossfire.
This focuses attention on Sebi’s layered mandate: to protect the interests of investors in securities, promote the development of markets for these assets, and, of course, to regulate them.
Ever since the Sebi Act was first legislated in 1992, the regulator has worked hard on a regulatory framework designed primarily to secure retail investors from volatility and market malpractices. Sebi has also spent considerable energy on market development.
However, in the case of its new closing-price formula, retail investors find themselves shut out of the action, effectively, by its complexity. Many who have neither the time nor resources to study specific stocks or mutual funds (MFs) tend to opt for exchange-traded or index funds.
Technically, day-end auctions could help improve price discovery, which would then reflect in better MF net asset values (and bigger retail holdings).
Plus, the new system is expected to overcome suspicions that the legacy set-up had nurtured price manipulation, especially closer to expiry dates for futures and options.
Whether these outcomes eventually come to pass, however, is a question for later.
Ambiguity exists because the auction system seems to have been launched in some haste. Even though Sebi had announced system migration through a circular on 16 January, the shift seems marked by a lack of due preparation.
Sebi’s senior brass should have anticipated some of the problems encountered over the past few days. Volatility that arose from apparent friction between the market’s new microstructure and lack of operational ease for arbitrage funds, for example, could have been held in check by prior stakeholder consultation.
The regulator had presciently introduced a sandbox facility, but it’s unclear whether it used that infrastructure to test the new system. Trial runs would have helped eliminate much of the uncertainty around closing auction sessions.
The change seems aimed at aligning Indian market trading with practices followed in developed countries, thus making it more familiar to FPIs that operate across the world. This is a laudable ambition, but its pursuit should not discomfit retail investors.