Market Calls for F&O Settlement to Be Separated From Closing Auction

India’s market participants appear to have reached a broad consensus on one of the key concerns surrounding the Securities and Exchange Board of India’s (SEBI) new Closing Auction Session (CAS): the mechanism should remain in place, but the settlement of expiring Futures and Options (F&O) contracts should be separated from the cash-market closing auction.

The view has emerged ahead of SEBI’s planned consultation on the settlement-price methodology. The regulator said on Thursday that it would review how settlement prices are calculated after sharp volatility was witnessed around expiry-day auctions.

The debate follows the first month of CAS, which was introduced to change the way official closing prices are discovered for eligible stocks. While the auction was designed to improve price discovery and bring Indian markets closer to practices followed by major global exchanges, its interaction with derivatives settlement has created concerns among traders and market professionals.

Keep CAS, but Separate F&O Settlement

Market participants are not necessarily calling for CAS to be scrapped. Instead, the dominant suggestion is to give the derivatives market a separate mechanism for determining expiry settlement prices.

The reasoning is straightforward: the cash-market closing auction and the settlement of large derivatives positions serve different purposes. Combining the two can leave the cash auction exposed to the effects of substantial F&O positioning, particularly on expiry days.

A separate expiry mechanism could allow CAS to focus on discovering the underlying stock’s closing price while preventing derivatives-related activity from placing excessive pressure on the auction.

Liquidity Emerges as a Major Concern

The experience of the first few weeks has highlighted the importance of liquidity in the new system.

Market participants have reported sharp movements during periods involving index rebalancing and derivatives expiry. Bank Nifty, for example, has experienced moves of several hundred points during the CAS window, while concerns have also emerged over the ability of the auction to absorb large order imbalances.

Retail participation has remained another challenge. Traders accustomed to continuous execution may be reluctant to participate in an auction where the probability of getting their orders executed can be lower.

This creates a potential cycle: limited participation can produce a thinner order book, while a thin order book can make market participants even more hesitant to participate.

Timing Creates Another Complication

The different closing schedules for cash equities and derivatives have also become an important part of the discussion.

Under the current structure, the cash market enters its auction phase while derivatives trading continues for longer. This creates a period during which options traders may not have continuous price discovery in the underlying stock.

That can make hedging more difficult, particularly for traders managing positions whose value is sensitive to rapid changes in the underlying price.

Market participants have therefore suggested changes to the timing of derivatives trading around expiry. One proposal is to end options trading earlier so that expiring contracts can be settled before the cash-market auction begins.

Another suggestion involves modifying the price band used during the auction to reduce the possibility of unusually large deviations.

Why SEBI Introduced CAS

SEBI introduced CAS as a new approach to determining official closing prices for eligible F&O stocks. The system replaced the earlier VWAP-based closing methodology and was intended to provide a more transparent and representative price-discovery process.

Under an auction mechanism, buy and sell orders are collected and matched at a price that allows the maximum possible quantity to be traded. The resulting equilibrium price becomes the official closing price.

The broader objective was to strengthen closing-price discovery and align Indian market practices with established international exchanges.

However, the initial experience has demonstrated that the effectiveness of an auction depends heavily on the depth and quality of participation.

Impact on Funds and Passive Investors

The issue extends beyond active traders.

Mutual funds, index funds and other passive investment vehicles can also be affected because official closing prices are important inputs for calculating portfolio values and Net Asset Values (NAVs).

Large orders placed around the close may face execution challenges if an auction becomes illiquid or the relevant price band is breached. This could potentially increase tracking differences for passive funds attempting to replicate an index.

Consequently, market participants are looking for a settlement process that is not only transparent but also sufficiently robust during periods of exceptional derivatives activity.

Extreme Expiry-Day Moves Raise Questions

The concerns have been reinforced by some striking price movements during the first month of CAS.

On monthly derivatives expiry sessions, the BSE Sensex experienced swings of more than 2,000 points within minutes during the auction period. Individual stock derivatives also recorded dramatic price changes.

One particularly notable example involved Dixon Technologies’ 15,000 Call Option. Its price moved from ₹2.65 to ₹104.90 before subsequently falling and settling at ₹0.05 on August 25.

Such movements have intensified questions about whether the closing price mechanism and derivatives settlement process should be allowed to interact so closely on expiry days.

SEBI Has Already Taken Action on Alleged Manipulation

The regulator has also acted against alleged market manipulation following the launch of CAS.

SEBI issued an interim order against Copthall Mauritius Investment and Mansi Share and Stock Broking and impounded ₹3.68 crore in alleged unlawful gains. The action related to alleged manipulative order placement that affected indicative prices during a Sensex auction on August 13.

The enforcement action underscores why the design of the auction needs to balance efficient price discovery with safeguards against attempts to influence indicative or final prices.

What Could Change Next?

The emerging market view suggests that the future of CAS may not involve abandoning the system altogether. Instead, the likely focus will be on refining how it interacts with derivatives.

A dedicated settlement mechanism for expiring F&O contracts could allow the cash-market auction to perform its intended role without simultaneously carrying the burden of settling large derivatives positions.

SEBI’s consultation will ultimately determine whether such changes are adopted. For now, the early experience with CAS has already provided the regulator with a substantial amount of market feedback.

The central question is therefore shifting from whether India needs a closing auction to how the auction can be structured so that cash-market price discovery and derivatives settlement work effectively without creating unnecessary volatility.