MSCI Rebalancing Threatens to Turn ‘Messy’ in New Indian Auction

India's new closing auction system for MSCI indexes is facing its most significant challenge yet with billions of dollars in passive fund trades flowing through it on Monday. The quarterly rebalancing of the MSCI indexes may trigger around $5 billion in trading turnover by global passive funds, with about $4 billion passing through the Closing Auction Session, according to Periscope Analytics' Brian Freitas. Freitas warns that the expected flow is almost 30 times what the auction typically handles.

The scale of the event is substantial compared to the auction's previous performances, with the Securities and Exchange Board of India's (SEBI) mechanism typically seeing about $125 million in daily turnover. The rebalance could spark concerns over sharp price swings, thin liquidity, and potential manipulation during the trading window, as traders have already seen a "flash crash" during the 20-minute auction last Thursday.

Passive funds must closely track their benchmarks, leading to large orders to buy or sell stocks when MSCI makes changes to its indexes. These trades are typically executed around the auction's effective close to minimize tracking error, concentrating demand and supply inside the window. MSCI said it will monitor the auction's effectiveness, taking feedback from market participants into account.

India's market regulator maintains that the auction is designed to reduce tracking error for passive funds and align the stock market with global standards. Recently, SEBI Chairman Tuhin Kanta Pandey reaffirmed that the new mechanism will remain in place despite growing calls for changes.

Following the latest quarterly review, MSCI will add Lenskart Solutions Ltd., Laurus Labs Ltd., Adani Energy Solutions Ltd., and Billionbrains Garage Ventures Ltd. to its standard indexes while removing Balkrishna Industries Ltd., SBI Cards & Payment Services Ltd., and Astral Ltd. The expected reduction in Reliance Industries Ltd.'s weight may trigger about $500 million in outflows.

Passive funds will likely execute most of these trades through the auction window to transact closer to the official closing price, but the scale of the rebalance may pose liquidity challenges for some less-traded stocks.