SEBI Gives Arbitrage Funds More Flexibility as Closing Auction Grapples With Thin Liquidity

India’s market regulator has given arbitrage mutual funds some room to carry temporary unhedged positions, as it looks to draw more liquidity into the country’s new closing auction for stocks, according to people familiar with the matter. 

Invest in Indian Markets and Unlock Future Potential With 5paisa!

Open Account Now

The Securities and Exchange Board of India (SEBI) has allowed arbitrage schemes to keep as much as 1% of their positions unhedged temporarily, the report said. Until now, the requirement to remain fully hedged had made participation in the closing auction difficult for these funds. 

The change could bring a sizeable pool of capital into the process. Arbitrage funds together managed about ₹3 trillion, or $31 billion, in assets at the end of August. 

Why arbitrage funds were finding the auction difficult 

Arbitrage funds typically look to capture price differences between shares in the cash market and their corresponding futures contracts. To manage that trade, their cash and futures positions are normally matched. 

Before the closing auction was introduced, price differences emerging during the final 30 minutes of trading gave arbitrage desks time to execute both sides of the transaction. 

The auction has changed that equation. 

A fund, for instance, may sell a futures contract with the intention of buying the same exposure through shares in the closing auction. If there are not enough sellers in the cash market, however, the purchase may not be completed. That leaves the futures leg temporarily without an equivalent cash position. 

Allowing an unhedged position of up to 1% gives funds some leeway to manage such situations instead of having to maintain a complete hedge throughout the process. 

Closing auction has struggled to attract liquidity 

The relaxation comes less than two months after the new closing auction was introduced on August 3. 

Participation has remained thin, with several institutional investors largely staying away. Low volumes have also made price movements more pronounced, complicating the process of establishing stable closing prices. 

The liquidity issue has already prompted a wider look at the framework. On Saturday, SEBI proposed changes to the closing auction mechanism, including the possibility of reverting to the earlier settlement method for derivatives on expiry days. 

Those proposals followed concerns around sharp price movements during the auction. 

AMFI communicated the relaxation to fund houses 

The Association of Mutual Funds in India communicated the 1% relaxation to asset management companies earlier this month, according to people familiar with the matter. 

Fund houses that decide to use the additional flexibility may need to communicate the change to their unitholders. 

Neither SEBI nor AMFI responded to requests for comment cited in the report. 

The reported relaxation is therefore another attempt to address the liquidity problem that has emerged since the closing auction went live. With arbitrage schemes managing roughly ₹3 trillion in assets, even limited participation from these funds could add another source of orders to a mechanism that has so far struggled to attract sufficient trading interest.