A Perfect Closing Price Is Not Enough

The stated objective behind SEBI's new Closing Auction Session (CAS) is difficult to quarrel with. Closing prices matter enormously. They determine index values, mutual fund NAVs, ETF tracking, derivatives settlement, margin calculations and portfolio valuations. A price discovered through a broad auction, rather than through a handful of trades in the dying seconds of the market, appears intuitively superior.

That is why most major markets around the world employ some form of closing auction.

Yet, a week into the Indian experiment, the debate is not about the merits of the objective. It is about the cost of getting there. The most visible outcome so far has been something markets can do without: unsettling end-of-day volatility.

The last few minutes of trading have always been important. Now they have become nerve-racking.

Sharp and sometimes inexplicable swings in closing prices have left traders scrambling, brokers fielding complaints and investors wondering whether the market's final verdict is being determined by fundamentals or by the mechanics of the auction itself. The unusual divergence witnessed between the Nifty and Sensex in the initial days of implementation only added to the confusion.

The problem is not volatility per se. Markets are supposed to react to information. When prices move because of earnings, economic data or geopolitical developments, investors understand the reason.

The concern is volatility generated by market structure.

When prices whip around because participants are adapting to a new trading mechanism, confidence inevitably suffers. Investors can tolerate losses arising from incorrect judgement. They are less comfortable with losses arising from uncertainty about how the market itself functions.

One criticism has attracted particular attention: the disconnect between the cash and derivatives markets.

Under the new framework, continuous trading in F&O-eligible stocks ends at 3:15 p.m. and the closing price is subsequently discovered through an auction process that concludes around 3:35 p.m. Meanwhile, equity derivatives continue trading until 3:40 p.m.

At first glance, this appears to create a mismatch. However, describing it as a complete cash-market shutdown would be inaccurate. The cash market is not closed; it is engaged in the process of discovering the closing price through the auction. Moreover, the auction-determined closing price is precisely what derivatives markets are meant to incorporate and anticipate.

Even so, the criticism cannot be dismissed entirely. During the transition period, traders are operating in an unusual environment where continuous price discovery in the cash market has ceased while derivatives continue to trade. This can temporarily complicate hedging, arbitrage and execution strategies, particularly on expiry days when every basis point matters. The sharp movements witnessed during the first few sessions might suggest that the market is still learning how to bridge this gap.

An equally important concern is what traders call the "blind-book" problem.

A continuous market allows participants to observe prices evolving in real time. An auction market is different. Orders accumulate and are matched at a single equilibrium price. While indicative prices are available, many participants feel they lack the visibility they are accustomed to during normal trading. This concern about limited visibility and uncertainty around closing prices might be contributing to the erratic market behaviour seen during the initial days.

Price discovery works best when participants have confidence in the process. If traders feel they are placing orders into a partially opaque system, the auction risks being perceived as a guessing game rather than a mechanism for efficient price formation.

Trust Test
To be fair, regulators and exchanges anticipated some of these concerns. Closing auctions are designed precisely because continuous markets can be vulnerable to last-minute manipulation. Randomised closing times and pooled order matching are intended to reduce the influence of opportunistic traders. Academic research on auction design has found that such features can improve auction efficiency and reduce strategic behaviour.

SEBI has stated that it has not found signs of abuse in the new system and believes participation will deepen as market participants become more familiar with the process. Mutual fund participation has reportedly increased significantly after the initial days.

But regulators should resist the temptation to judge success solely by the absence of manipulation.

A market structure reform must satisfy a broader test. It should not merely produce a technically sound closing price; it should also produce confidence in that price.

This is where the invocation of "global best practice" deserves closer examination.

Global markets use closing auctions because they are supported by deep pools of institutional liquidity, active market makers and years of participant familiarity. Importing the mechanism is easy. Importing the ecosystem is harder.

The question is therefore not whether New York, London or Tokyo use closing auctions. The question is whether the Indian market, in its current form, can transition to the new system without imposing high costs on investors and traders.

Perhaps the recent turbulence is merely a teething problem. Participation may deepen, liquidity may migrate to the auction window, and today's volatility may eventually disappear. That is certainly possible.

But until that happens, the experience of many market participants will remain difficult to ignore. A reform introduced to make closing prices more representative has made the closing minutes more unpredictable. A mechanism intended to inspire confidence has, at least temporarily, increased anxiety.

Markets need efficient price discovery. They also need trust.

If investors begin approaching the closing bell with apprehension rather than confidence, regulators may discover that the real challenge is not discovering the right price. It is preserving faith in the process that produces it.