SEBI Permits Arbitrage Mutual Funds 1% Unhedged Leeway to Improve Closing Auction Session Liquidity

The Securities and Exchange Board of India (SEBI) has granted temporary operational leeway to arbitrage mutual funds, allowing them to carry unhedged positions of up to 1% of their assets under management (AUM). The intervention is designed to inject vital institutional liquidity into the equity market's Closing Auction Session (CAS), an end-of-day pricing mechanism that has faced liquidity hurdles since its rollout on August 3, 2026.

The Association of Mutual Funds in India (AMFI) has communicated the update to asset management companies following consultations with the capital markets regulator.

Resolving the Execution Mismatch Dilemma

Arbitrage funds, which held combined assets of approximately ₹3 lakh crore ($31 billion) as of August 2026, generate low-risk returns by capitalizing on mispricings between the cash equity market and futures contracts. By mandate, these funds must remain fully hedged, holding offsetting positions in both segments to eliminate directional market risk.

Prior to the structural overhaul, closing prices were determined using the volume-weighted average price (VWAP) across the final 30 minutes of regular trade (3:00 PM to 3:30 PM). This half-hour window gave arbitrage desks adequate time to identify pricing gaps and systematically execute simultaneous orders in cash shares and futures contracts.

Under the CAS framework—designed to establish an equilibrium closing price via a dedicated call auction for stocks with derivatives contracts—trading ends earlier, concentrating closing order matching into a shorter, single-price auction. This shift introduced major execution risks for arbitrage desks:

• An arbitrage fund placing an order to sell futures contracts while attempting to purchase underlying shares in the closing auction could face partial fills in the cash segment due to thin auction depth.
• Under previous rigid compliance norms, any unfilled order left the fund with an illegal unhedged position, exposing fund managers to regulatory breaches.
• Consequently, major institutional desks chose to stay away from the closing auction, further dampening traded volumes.

The newly sanctioned 1% unhedged cushion allows asset managers to absorb temporary settlement and execution mismatches overnight without violating portfolio mandates.

Wider Structural Review Underway

The move comes amid broader scrutiny of the closing auction mechanism. Institutional market participants have expressed concerns that light volumes during the auction session have exacerbated end-of-day price gyrations rather than smoothing them out.

In response to market feedback and sharp swings observed particularly on derivatives expiry days, SEBI has also been evaluating adjustments to the framework. Among the proposals being reviewed is whether to alter the settlement formula on expiry days or revert to earlier pricing methodologies for contract expiries to preserve market stability.

Implications for Market Participants

For retail mutual fund unitholders, arbitrage funds are popular as tax-efficient alternatives to liquid and ultra-short-term debt instruments. By giving fund managers operational flexibility to participate in closing auctions, the relaxation can help desks capture mispricings that emerge near the closing bell, while the tight 1% cap ensures the overall risk profile of the scheme remains firmly anchored.

For the broader market, drawing the ₹3 lakh crore arbitrage fund segment into the closing auction is expected to deepen the order book, reduce impact costs for institutional transactions, and assist exchanges in establishing fair end-of-day benchmark valuations.

Tags: SEBI AMFI NSE BSE Mutual Funds Arbitrage Funds