SEBI is said to ease arbitrage fund rules to aid auction

The Securities and Exchange Board of India (SEBI) is set to allow arbitrage mutual funds greater flexibility in managing their positions, in an attempt to inject much-needed liquidity into the closing auction for stocks, according to sources familiar with the matter. This easing of rules enables these funds to temporarily hold unhedged positions amounting to up to 1% of their portfolios, according to the sources, who declined to be identified due to the sensitive nature of the information.

As of the end of August, arbitrage funds had amassed a combined asset base of 3 trillion rupees ($31 billion). The decision comes as the auction process has been grappling with attracting sufficient participants since its inception on August 3. Arbitrage funds make their profits by capitalizing on price discrepancies between the cash equities and futures markets.

However, the stringent hedging requirements have limited their involvement in the auction process. Previously, price fluctuations during the final 30 minutes of the trading day allowed arbitrage desks to close any temporary gaps between cash shares and futures, but the recent auction format has significantly reduced that window, thereby increasing the risk of a temporary mismatch.

With the new allowance, funds will be able to carry over these mismatches instead of adhering to full hedging at all times. SEBI's move aims to address one of the auction's most significant challenges: the scarcity of liquidity. The regulator has also proposed comprehensive reforms to the closing auction framework, such as a potential return to the earlier method of settling derivatives on expiry days, following reports of sharp price swings.