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Mumbai: The Securities and Exchange Board of India (Sebi) is likely to adopt a blended pricing framework for calculating settlement prices in the derivatives segment, seeking to curb sharp price swings and distortions on weekly and monthly options expiry days, according to three people aware of the development. The proposed approach would combine the volume-weighted average price (VWAP) of trades during the last 30 minutes of continuous trading with prices discovered in the 10-minute closing auction session (CAS). This would reduce reliance on the auction alone to determine settlement prices, which has contributed to volatility amid thin trading volumes since the new system was introduced on 3 August. “The market regulator is likely to consider a blended VWAP from the get-go. The idea is to delink the pricing from being derived solely by CAS. If you delink it using VWAP, that should solve the problem,” said one of the people. Sebi reviewed the framework through a consultation paper in September, following pushback from market participants over a liquidity squeeze during the auction. The paper outlined two alternatives for calculating closing prices on derivatives expiry days: adopt a blended VWAP-based methodology or retain the existing VWAP calculation based on the last 30 minutes of continuous trading on settlement days for at least a year. Unlike a simple average, VWAP takes into account both the price and volume of trades. For instance, if 100 shares are traded at ₹10 each and 50 shares at ₹12 each, the VWAP is ₹10.67, compared with a simple average price of ₹11. Sebi chairman Tuhin Kanta Pandey said on 10 October that the regulator would issue final guidelines on CAS in “about a week’s time”. An emailed query to the regulator did not elicit a response. Many market participants have urged Sebi to retain VWAP-based settlement pricing on expiry days—Tuesday for Nifty options and Thursday for Sensex options—and introduce blended pricing on non-expiry days for a year before transitioning fully to the blended framework. Market ``participants believe that CAS would become more liquid after a one-year time frame,” said D.K. Aggarwal, chairman and managing director of SMC Capitals Ltd. However, a blended pricing mechanism without a one-year transition period would also “rectify the price distortions” witnessed on expiry days, he added. Why CAS has struggled CAS is an auction-based price discovery mechanism used in major global markets and is generally preferred over VWAP for determining closing prices. However, the system has yet to attract sufficient trading volumes in India. Initial operational challenges, including the need for market participants to modify their trading software and the early closure of the continuous trading session (CTS), have kept some participants, including arbitrage funds, away. Passive funds, such as exchange-traded funds (ETFs) and index funds, have been more active in the auction. Volumes on the CAS on NSE, at around ₹1,000-1,200 crore, are roughly a fifth of those recorded during the final 15 minutes of the earlier continuous trading session, said Shai Coelho, founder of Pune-based analytics firm Vtrender. This could skew options prices on settlement days, he added. But, the blended mechanism will work to redress this . Before 3 August, continuous trading in both the cash and derivatives segments ran from 9:15 a.m. to 3:30 p.m., with closing prices determined using the last 30 minutes of trading. On expiry days, derivatives and spot prices converge. Under the CAS framework, continuous trading in the cash market ends at 3:15 p.m., followed by a 10-minute auction from 3:20 p.m. to 3:30 p.m. The derivatives trading session continues until 3:40 p.m. Under the proposed blended methodology, the settlement price for 213 stocks, including those in the Nifty and Sensex indices, would be calculated using a combination of VWAP during the final 30 minutes of continuous trading and prices discovered during the 10-minute CAS. The calculation would use the combined VWAP across exchanges, based on the actual value of trades during the relevant periods, with the continuous trading session accounting for a larger share of the settlement price than the auction. According to the people cited above, the blended calculation could use the VWAP for either 2:45-3:15 p.m. or 3-3:30 p.m., combined with the CAS price for either 3:20-3:30 p.m. or 3:30-3:40 p.m. Under the current system, derivatives settlement prices are based on the relatively illiquid 10-minute auction, leaving them vulnerable to distortions caused by large orders. “It’s unlikely that the regulator would want to have two pools of liquidity, one VWAP for the weekly and monthly expiry days and the other blended price on non-expiry days . This will not solve the problem of low liquidity during the 10-minute closing auction session ,” said the second person, referring to the alternative of retaining the existing VWAP-based methodology on expiry days for a year. Sebi is also likely to proceed with a proposal to restrict the cancellation of limit orders priced beyond ±1% of the reference price, the three officials mentioned above said. The price band applicable during CAS is ±3% of the reference price. During the auction, some participants were found placing limit orders at prices 3% above or below the reference price, which is determined using trades in the final 15 minutes of continuous trading, and then cancelling the orders. Such a practice can contribute to sharp price swings on weekly and monthly options expiry days. "A cancellation of order closer to the price band leads to prices being influenced heavily. The move is expected to curb such price swings that have kept several participants away from the closing auction,” said the first person.
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