SEBI Gives Arbitrage Funds 1% Leeway on Unhedged Positions to Boost Closing Auction Liquidity

India’s market watchdog, the Securities and Exchange Board of India (SEBI), has quietly tweaked the rules for arbitrage mutual funds. For now, these funds can hold a modest un‑hedged exposure – up to one percent of their portfolio – instead of being forced to stay fully hedged at all times.

Why does this matter? The change is meant to coax a little extra liquidity into the stock‑closing auction, a mechanism that’s been limping along since it was rolled out on August 3. Participation has been thin, and price swings have sometimes been a touch wild, making it harder to lock in a smooth end‑of‑day price.

Arbitrage funds, which sit on a combined Rs 3 trillion (about $31 billion) of assets as of the end of August, traditionally profit from fleeting price gaps between the cash equity market and futures contracts. Under the old rule, they had to keep every trade perfectly hedged, a constraint that limited their ability to step in when the auction’s 30‑minute window left a temporary mismatch between cash shares and futures.

With the new one‑percent leeway, a fund can, for example, sell futures and intend to buy an equivalent amount of shares in the closing auction – and if the cash side is a bit thin, the fund is allowed to carry that slight imbalance instead of being forced to unwind immediately.

SEBI isn’t doing this in a vacuum. The regulator has also floated broader tweaks to the auction framework, even hinting at a return to the earlier method of settling derivatives on expiry days after observing sharp price swings. The goal across the board is simple: get more institutional players back into the auction and smooth out the price discovery process.

According to sources, the Association of Mutual Funds in India (AMFI) has already passed the memo along to asset‑management companies. Any fund that decides to use the extra flexibility will likely need to inform its unitholders, although the exact communication protocol is still being worked out.

When approached for comment, representatives of SEBI and AMFI declined to speak, citing that the details are not yet public. Still, the move signals a willingness from regulators to adapt rules when market dynamics call for it, and arbitrage funds appear ready to test the waters.