A liquidity mismatch for CAS

Until the start of August, the closing price of stocks with derivatives was determined using the volume-weighted average price (VWAP) over the final 30 minutes of trading. This price matters because it used to settle the derivatives contracts on expiry day. But VWAP had some shortcomings. A large order placed toward the end of the session could significantly influence the closing price, while other market participants had limited visibility into the likelihood or timing of such an order before it was executed. So Sebi brought in the Closing Auction Session (CAS), beginning August 3. Now all closing orders go into one window and match at a single price, with an indicative price displayed throughout the window. Sebi expected this mechanism to improve price discovery by allowing large orders to be absorbed with lower price impact. In turn, the mechanism was expected to make expiry days more orderly.

Yet on the last Thursday of August — the first monthly expiry under the new closing auction regime — the Sensex’s indicative price fell some 2,200 points during the auction window, and then clawed back most of the drop within minutes. The premiums on BSE options swung even harder: one contract surged an astonishing 4000% before crashing towards zero. The immediate instinct is to blame the auction system, and it may well have amplified the swings. But the real culprit is the huge liquidity mismatch between cash and derivatives markets in India.

India runs one of the world’s largest equity-options market, alongside a relatively thinner and less liquid cash market. Consider the proportions. On a normal day, the notional value of index derivatives traded runs 300 to 400 times the turnover in the underlying shares (figure 1). On expiry days, when options market activity spikes, the ratio can balloon to as much as 3,000. For comparison, in most developed markets, the number is far more grounded (5 to 15). This mismatch is what India ultimately has to address.

To see why the mismatch matters, consider a trader who trades options and holds just enough of the underlying shares to offset the position’s directional exposure, its delta — a strategy also known as delta-hedging and employed by institutional investors. The catch is that an option’s delta shifts violently as expiry nears and the price hovers around the strike. Keeping the position delta-neutral therefore forces the trader to buy and sell the underlying again and again — in a cash market that is already thin, so each rebalancing trade moves the price and feeds the very volatility the hedge was meant to neutralise. Thin participation in the auction only makes this worse. Data so far suggest that less than 5% of daily trading activity now flows through the CAS window (figure 2), down from around 10% before the transition. In a market with this kind of liquidity mismatch, derivatives hedging can end up driving the price of the underlying shares rather than the other way around.

The same mismatch invites a second problem: manipulation. If you hold a large options position, one way to make it pay is to nudge the handful of shares that set the index. A few hundred crore rupees deployed in a thin cash market can shift the settlement price against which contracts worth thousands of crores are settled. Sebi’s interim order against Jane Street alleges that the firm used such a strategy. And Sebi’s recent interim order against Copthall Mauritius Investment Limited and Mansi Share and Stock Broking Private Limited over prima facie manipulative trades during the auction suggests that CAS has not eliminated the problem either, in part because it has yet to attract sufficient liquidity.

This points to the only durable fix. Tinkering with the last 20 minutes will not help until the imbalance beneath it is addressed, and there are only two ways to do that. One solution is to deepen the cash market by making short selling easier for investors, creating genuine two-sided flow that makes the closing price harder to move. The other is to narrow the gap in the cost of speculation between options and the underlying shares. An investor can build a large position in the derivatives market with substantially lower capital than would be required to take an equivalent position in the underlying. As long as that differential persists, options will keep attracting disproportionate volumes, and the problem is likely to persist. Therefore, Sebi needs to take steps that make speculating in options more expensive. Its recent moves — larger lot sizes, higher securities transaction tax, fewer weekly expiries on some indices — are a good start. However, the recent data shows these steps have had only limited impact (figure 1). The the gap they were meant to close remains substantial.

The auction was never a problem. The mismatch beneath it is — and until that narrows, no closing mechanism that Sebi designs can eliminate the chaos that Indian financial markets experience on expiry days.

Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.