SEBI Relaxes Arbitrage Fund Rules to Boost Closing Auction Liquidity

The Securities and Exchange Board of India has granted arbitrage mutual funds temporary flexibility to carry unhedged positions of up to 1% of their assets under management. This regulatory adjustment, communicated to asset management companies earlier this month by the Association of Mutual Funds in India, is designed to encourage participation in the stock market's closing auction session, which has faced significant liquidity challenges since its launch on August 3.

Arbitrage mutual funds, which held a combined ₹3 lakh crore in assets as of late August, typically operate by exploiting price discrepancies between cash equities and futures markets. Under previous regulatory requirements, these funds were mandated to remain fully hedged at all times. However, the introduction of the closing auction session shortened the window for executing these trades, creating a heightened risk of temporary mismatches where a fund might sell futures without being able to immediately purchase the corresponding shares in the cash market.

By allowing a 1% unhedged allowance, the regulator enables funds to carry these temporary mismatches rather than forcing them to maintain a perfectly hedged position. This flexibility is intended to lower the barrier for arbitrage desks to enter the auction, thereby increasing trading volumes and helping to stabilize end-of-day price discovery.

The closing auction session has struggled to attract institutional investors since its inception, with thin volumes often leading to increased price volatility. Market participants have frequently cited these thin volumes as a primary reason for staying away from the session. The current relaxation is part of a broader regulatory effort to refine the auction framework. On September 12, SEBI proposed additional sweeping changes to the system, including a potential return to previous methods for settling derivatives on expiry days, following concerns regarding sharp price swings.

While the new allowance is expected to facilitate greater participation, industry sources indicate that funds choosing to utilize this 1% leeway may be required to formally communicate the change to their unit holders. Representatives for both SEBI and the Association of Mutual Funds in India did not respond to requests for comment regarding the implementation of these rules.