India beats a hasty retreat from a crucial market reform

After only a month of teething troubles and loud howls of protest, one of the biggest reforms in India’s capital markets in recent years risks being watered down — if not entirely jettisoned.

In early August, the Securities and Exchange Board of India directed local bourses to discover end-of-day prices via a final 20-minute auction. This was meant to stop large traders from manipulating closing prices under cover of all-day continuous trading, a strategy known as “marking the close.”

It’s also one of SEBI’s as-yet-unproven allegations against Jane Street Group. The Indian regulator sent ripples across global trading rooms by freezing some of Jane’s index-option profits in June last year, alleging that they came from distorting prices of the underlying stocks. The New York market maker has denied the allegations as a fundamental misreading of its strategy and is pursuing an appeal before a tribunal.


But apart from adopting a more aggressive stance against Wall Street heavyweights, what could SEBI do to make the cash market more honest? The regulator rightly judged that policing alone wouldn’t suffice. Manipulation had to be nipped at the source.

The stakes are high. For some years now, authorities have been alarmed by India’s rise as the world’s largest options trading venue. The boredom of pandemic lockdowns had unleashed a wave of thrill-seeking behavior among individual investors globally, aided by zero-brokerage apps and short-expiry derivatives. In India, reckless speculation continued long after Covid-19, with the notional volume of equity derivatives trading peaking at a staggering $6 trillion in February 2024.

With nine out of 10 retail investors losing money trading derivatives, the whole craze was threatening to become a social menace, especially among younger men. As the wait for white-collar jobs kept getting longer, they had all the time in the world — and access to social-media “finfluencers” — to splurge on leveraged bets they couldn’t afford. While curbing retail speculation, the regulator began to probe if Big Whales were guaranteeing the success of their options trades by rigging the much smaller and less liquid cash-equity market.

Most global bourses discover closing prices by halting continuous trading and switching to an auction for the last few minutes. An equilibrium price where most orders can be matched is declared as final.

Since any attempt to game an auction is quickly detected, SEBI moved about 200 derivative-linked stocks to a closing auction system. Then everything went haywire.

Intraday trends reversed abruptly in the 20-minute auction window — stocks strongly green at 3:15 p.m. plunged deep into the red by 3:30 p.m., and vice versa. Option volatility exploded, and local investors decried the system as unworkable.

SEBI finally lost its nerve. Over the weekend, it released a new consultation paper offering two options. The regulator could either shorten the auction to minimize its impact, or strip it from derivative settlement for at least a year and return to a 30-minute trading average. If SEBI chooses the second option after public feedback wraps up, the market will largely limp back to its old ways.

The regulator's loss of faith in its own reform is a disappointing turn. Worse, the true villain of the saga is not getting enough attention. After all, if investors are behaving irrationally in the closing minutes, why aren’t arbitrageurs swooping in to enforce more orderly price discovery?

The simple answer is taxation. Securities transactions have been taxed by New Delhi since 2004, but rates have climbed to prohibitive levels. After the most recent increase announced in the budget, an arbitrageur who could stabilize prices by going long cash and short futures has no incentive to do so after paying a 0.05% tax on the total contract value.

This gives rise to a chicken-and-egg problem. As capital pools that could trade away inefficiencies stay away, the market becomes even shallower. Traders’ inability to execute large orders without moving prices further diminishes the profit potential from arbitrage.

The finance ministry should have reworked its tax policies before SEBI adopted the auction method. A breakdown in fiscal-regulatory coordination is what doomed the reform.

Exorbitant taxation has other important side effects. Many day traders dabbling in derivatives who would have otherwise remained profitable became net loss-makers after paying transaction costs — those accounted for more than a third of their gross losses. But what are these costs? While broker commissions and exchange fees are falling, the securities transaction tax collected from retail investors has ballooned: to 66 billion rupees ($691 million), from 13 billion rupees four years ago.

The regulator is not off the hook, though. A well-functioning cash market needs both bullish and bearish views. But short sellers struggle to borrow stocks. That’s because SEBI — scarred by earlier scams where bank money was used illicitly to fund speculative positions — tries to micromanage what should be a private transaction between lenders and borrowers.

All of this is compounding the lack of liquidity. A cash market that resembles a small pond is getting in the way of both Big Whales and small fish. Reforms must boost depth. But after the latest botched attempt, it may be some time before the regulator can muster the confidence to try again.