Capital market development and institutional apathy

Last month, India's capital market regulator, the Securities and Exchange Board of India, introduced the system of closing auctions to determine the closing prices of securities in line with global best practices. The system has proved quite controversial because of thin liquidity, wild price fluctuations, and alleged market manipulation. Samir Barua has a nice post that provides a comprehensive analysis of the issues involved, and presents a balanced picture of the situation.

As Samir highlights in his post, the closing price matters a lot. It affects mutual fund daily valuation, corporate balance sheets, and institutional risk management measures like the daily value at risk. But all these examples show that the closing price matters far more to institutions than to retail investors who can afford to treat it as just another number on the screen. The markets are open only about 6 hours out of 24, and retail can merrily choose to trade only for 5½ hours. Institutions cannot opt out so easily because the closing price impacts them significantly. The closing auction is in this sense very different from the auction at the open which investors of all hues have chosen to ignore.

So the real issue about thin liquidity in the closing auction is the lack of institutional participation. One interesting data point drives this point home. August 31 was the implementation date for the August 2026 changes in the MSCI Global Indices that are tracked by many institutional investors. That day, the closing auction passed off without any glitch with a trading volume exceeding the total volume for all the other days of the month put together. Closing auction volumes fell back to miserable levels on the next day.

This demonstrated two important facts:

1. The closing auction works smoothly when there is large institutional participation.

2. But institutions will participate only when there is a gun pointed to their heads.

It has always been thus. Fifteen years ago I wrote:

Unfortunately, however, ... [institutional] actions have been characterized by not merely an indifference to reforms but also active resistance to them. ... Many of these reforms have had to be pushed through by regulatory fiat even where they were in the long-run interest of the institutions themselves. In this sense, institutions have been as myopic in their response to capital market reforms as any other actor. ("Indian Financial Market Development and Regulation: What Worked and Why?", in Kawai, M. and Prasad, E., 2011. Asian perspectives on financial sector reforms and regulation. Asian Development Bank Institute.)

In that paper of 2011, I gave several examples of this

• Before India set up its first depository, institutions were most vociferous in their complaints about the risks and costs of the paper-based settlement system. But when the depository started operations, they were most reluctant to start using its services ... The regulator finally had to mandate that institutions could trade only in dematerialized form. Because of the regulatory push, virtually the entire trading shifted to dematerialized form within two years.
• For a long period during the 1990s, when an optional rolling settlement facility was available in India, institutions did not embrace the facility at all. Ultimately, the shift toward rolling settlement happened only when the regulator made the new system mandatory.
• [A]fter the derivatives markets were set up, institutions were reluctant to trade in it. What happened was that retail investors built the market over a period of several years. Once they had created a critical mass of liquidity, institutional investors, who had been largely bystanders till then, came in as free riders. ... The same story has been repeated in the currency futures market.

Institutional investors have consistently failed to make the required investments in market development that academics and policy makers expect from them even where the market development benefits them disproportionately in the long run.

I suspect that the Closing Auction System is yet another chapter in this unfortunate saga. Perhaps, the regulator will have to point the gun at their head once again. (To give one random example, position limits in the derivative market could be linked to participation in the closing auction.)

Posted at 1:42 pm IST on Tue, 8 Sep 2026         permanent link

Categories: equity markets, Indian financial sector, regulation

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