India’s New Market Close: Impact on Arbitrage Funds

Starting Monday, Indian exchanges will implement a new closing auction system for equity markets, standardizing their approach with major global peers. This shift, however, could significantly impact arbitrage funds, which have historically capitalized on price dislocations during the final trading minutes.

Understanding the Shift in Closing Price Calculation

Previously, India’s stock closing prices were determined by trades executed in the last half-hour of the session. This method often created opportunities for arbitrage strategies to profit from growing price differences as the market neared its close.

The new auction system, a practice common in markets across Europe and the US, aims to reduce volatility during busy final trading minutes. Key aspects of this mechanism include:

• The auction session will last for 20 minutes, commencing at 3:15 p.m. Mumbai time.
• This change effectively shortens the trading day by 15 minutes for participants adjusting or hedging cash positions.
• During the final five minutes of the auction, buy and sell orders will be matched to establish a closing price.
• This closing price will be calculated to be within 3% of the 3:15 p.m. reference price, limiting wild swings.
• The system applies specifically to stocks with derivatives tied to them.

Stocks without associated derivatives, along with options and futures, will maintain their existing closing times. These will continue to close at 3:30 p.m. and 3:40 p.m. respectively, operating outside the new auction framework.

Arbitrage Funds Face Reduced Payoff

The introduction of the closing auction could diminish returns for India’s roughly $36 billion arbitrage fund industry. Eshaan Lazarus, co-founder and chief executive officer of 021 Trade, indicated this could shave returns by 10 to 15 basis points.

Lazarus noted that “some of the payoff for arbitrage funds could disappear” and that “the last stretch of the market is typically where the maximum opportunities lie.” The precise impact will become clearer once the changes are fully implemented.

Arbitrage funds, which attract investors seeking stable, debt-like returns with equity fund tax benefits, primarily profit through a specific strategy:

• Buying shares in the cash market.
• Additionally, simultaneously selling futures that are trading at a premium.
• Spreads are typically wider at market open and just before close due to increased price swings.

This new challenge comes as the arbitrage fund industry already faces pressure from a higher securities transaction tax on derivatives. Data from Value Research shows fund returns have declined to 5.8% in the past 12 months, falling below their annualized three-year average of 6.7%.

Enhancing Market Appeal for Global Investors

India’s securities regulator stated that the closing auction will facilitate easier execution of large orders and ensure a fair price for reference. This reference price is crucial for aspects like derivatives settlements and determining index levels.

According to Kruti Shah, a quantitative analyst at Equirus Securities, this move aligns India’s market structure with global standards. Shah explained that “Global investors are already familiar with closing auctions because that’s how most major exchanges determine benchmark prices.”

The shift is expected to enhance India’s market appeal to institutional investors. Shah added that “As liquidity migrates into the auction, execution quality should impr…”

By adopting a closing auction, India aims to modernize its equity market operations and foster greater confidence among a broader base of investors. This strategic alignment with international practices could refine market efficiency, even as it reconfigures established arbitrage opportunities.