In today’s Finshots, we tell you how SEBI’s new proposal could change the way Indian stocks get their closing prices.

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The Story

How do stocks get their prices?

“Come on, Finshots, we already know this!”, you might think. “It’s basic economics. Demand and supply determine stock prices.”

And you’re not wrong. Once a company is listed on the stock exchange, buying and selling activity does dictate whether its stock price moves up or down.

But then, demand and supply don’t directly decide a stock’s closing price. Right now, in India, we use something called the Volume Weighted Average Price, or VWAP. Sounds fancy, but it’s simple enough.

To calculate the closing price of a stock, market regulator SEBI (Securities and Exchange Board of India) looks at its price movements in the last 30 minutes of the trading day. But it doesn’t just take the prices, it also looks at how many shares were traded at these price points. For example, if most trades happened at ₹100, that price carries more weight than a few trades at ₹110. It’s like finding an average. But it’s not perfect.

Because the VWAP system has its flaws, especially when it comes to passive funds. If you’re wondering what those are, think of them as funds that track a market segment or mimic a stock market index, like the NIFTY 50 or BSE SENSEX. Fund managers here don’t actively pick stocks. Instead, they simply buy or sell stocks in the same proportion as the index changes. That way their returns match the index as closely as possible.

But here’s the catch. Passive funds base their trades on the closing price of stocks. And since closing prices are determined using VWAP, it can sometimes deviate the fund’s performance from the main index. And the result of this is something called a tracking error or a small difference between the fund’s returns and the index’s performance.

To put it simply, imagine that a stock called Hello Ltd. mostly trades around ₹100–₹101 during the day. But right before the market closes, someone carries out a huge trade at ₹110. This outlier affects VWAP, pulling the average closing price down to ₹105. So now, while the index considers Hello Ltd.’s value as ₹110, the passive fund buys it at ₹105. This mismatch means that the fund pays less, while the index shows a higher return. And investors don’t like that.

And this issue is snowballing because passive funds in India now manage assets worth nearly ₹11 lakh crores. That’s 6 times more than in 2020. Add to it the fact that the weight of Indian stocks is growing in global indices, and last-minute price distortions can have a big ripple effect. They can amplify the tracking error, making it harder for passive funds to mirror their returns.

But that’s not all. On certain days, like index rebalancing days, when big changes happen to stock indices (think adding or removing companies), the stock prices can get pretty crazy in the last half an hour of trading. You could look at what happened when MSCI, a global index provider, updated its indices a few months ago. On those days SEBI noticed that the volatility in NIFTY 50 stocks during the last 30 minutes was at least 1.5 times higher than during the rest of the day. And for bigger companies in the MSCI Global Standard Index, the volatility was a whopping 3 times higher!

Besides, these VWAP quirks also impact derivatives. For the uninitiated, derivatives are financial contracts that get their value from an underlying asset like a stock, currency or commodity. And on derivatives expiry days, when these contracts are set to expire, volatility can mess with their value too.

That’s exactly why SEBI wants to change how we calculate stock closing prices. It wants India to follow the lead of markets like the US, UK, Japan, Hong Kong and South Korea, and replace the VWAP by introducing something called a Closing Auction Session (CAS).

How will that change things, you ask?

See, in a CAS, an auction kicks off right after the market closes. Buyers and sellers submit stock price and quantity preferences. And the price at which most number of shares can be traded or where demand matches supply becomes the closing price. Quite simple. It aligns with market sentiment, minimises tracking errors and avoids last minute distortions.

To understand this, we could go back to Hello Ltd.’s example again. Let’s say 300 buyers and sellers agree to trade Hello Ltd. at ₹101 during a CAS. Well, that becomes Hello Ltd.’s CAS closing price. Clear, fair and far less gameable than VWAP.

So yeah, this auction mechanism ensures transparency. Everyone gets to see the true demand and supply dynamics in action. No more abrupt trades skewing prices unfairly. Investors, especially those in passive funds, can breathe a little easier knowing that their trades are based on prices that reflect real market activity, and not anomalies.

But hey, CAS isn’t foolproof either.

You see, when Hong Kong introduced it in 2008, it quickly ran into trouble. In just 10 months, they had to suspend it due to a manipulation loophole. Take the example of HSBC. As one of the world’s largest banks, its stock heavily influenced Hong Kong’s market. On a typical day in March 2009, its estimated closing price ranged between HK$37 and HK$38. But right before the market closed, a trader sold a massive 5 million shares, causing its price to plummet 10% to HK$33 in just a matter of seconds. But when the market reopened the next day, the price bounced back to HK$37.25, hinting that the dip was artificial.

The scandal forced Hong Kong to suspend CAS and reintroduce it years later in 2016 with safeguards. The new system only allowed CAS for major index stocks, capped price movements at ±5% from the last traded price and introduced the process in stages to monitor its effectiveness.

And now, SEBI might follow suit too. It plans to roll out CAS in a similar way, starting with stocks that have derivatives and enough liquidity. This makes sure that the system is only applied to stocks that are actively traded, making it more effective.

The challenge, though?

CAS could be trickier for investors to grasp than VWAP. And it also requires strong technology to handle the auction process, match orders and prevent any delays or mistakes.

On top of that, it adds extra time to the trading day, which could lead to higher operational costs for brokers and exchanges — something that could be a burden for developing markets like India.

So, will investors be on board with this change? Only time will tell.

Until then…

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