India’s new closing auction risks driving away high-frequency traders

India's revamped stock-market closing auction, designed to enhance price discovery, is facing a challenge from high-frequency and proprietary trading firms. Bloomberg reports that these firms, which contribute roughly one-third of turnover on the National Stock Exchange of India, are largely opting out due to difficulties in efficiently hedging or establishing short positions under the new securities-lending framework.

The new auction system requires traders to submit buy and sell orders within a 20-minute window, and the exchange determines an equilibrium price, marking a shift from the previous method based on the volume-weighted average of trades during the final 30 minutes of trading. This change poses problems for fast-moving trading firms, particularly those relying on short-selling strategies, as India's existing lending arrangements can expose them to extended short positions.

The Securities and Exchange Board of India has formed a panel to review potential reforms to the short-selling framework. Despite initial signs of liquidity improvement during the first auctions, trading activity has been weak, with average turnover in Nifty 50 constituents during the closing period falling below $100m in the first two sessions, significantly lower than the $700m seen under the previous system.

For India to succeed with the new auction, enhancing securities lending and short-selling ease, reducing inconsistencies between financial instruments, and fostering genuine market makers is crucial. Without these changes, the closing auction may remain thin, potentially leading to increased price distortions rather than the anticipated deeper liquidity and robust price discovery.