NextFin News - India's proprietary traders have pulled back to their smallest footprint in almost two years, as a one-two punch from the Reserve Bank of India's tighter funding rules and the Securities and Exchange Board of India's new closing-price auction has drained liquidity from the final minutes of the trading day. Proprietary desks' combined share of index and stock options on the National Stock Exchange fell 62 basis points to 47.3% in August, the lowest since October 2024, according to the exchange's latest Market Pulse data. The retreat matters because prop desks are the market's marginal liquidity providers - the players willing to hold inventory and absorb order flow when everyone else is moving the same way. When they step back, price discovery gets thinner, and the cost of that thinness is now being paid by index funds, arbitrage desks and retail traders alike.
The Two Shocks That Squeezed Prop Desks
The first shock arrived on 1 July, when banks began requiring proprietary traders to post 100% collateral for funding, up from 50%, under an RBI directive. The change effectively choked off access to bank guarantees, the cheap assurance mechanism props used to backstop payments to counterparties if a client defaults. Bank guarantees typically carry a commission of 1.5% to 2%; the alternative - raising money through non-convertible debentures - costs 9% to 10% in interest, according to D.K. Aggarwal, chairman and managing director of SMC Capitals. That is not a marginal increase in the cost of doing business. It is a change in the economics of the business.
The second shock landed on 3 August, when SEBI introduced the Closing Auction Session for the 213 stocks with listed derivatives, including every Nifty and Sensex constituent. The old system priced a stock's close on the volume-weighted average of the final 30 minutes of continuous trading. The new system discovers a single closing price through a dedicated 20-minute auction running from 3:15 p.m. to 3:35 p.m., with equity derivatives trading extended to 3:40 p.m. The stated goal was cleaner price discovery, matching the single-price close used in other major markets. The immediate effect was to pull liquidity out of the continuous session and concentrate it into a window where fewer participants are willing to stand in.
The data shows where the volume went. NSE's average daily premium turnover in equity options fell 15.7% month-on-month to ₹42,332 crore in August. BSE's options turnover dropped a steeper 26% to ₹18,672.32 crore. Of the ₹7,879 crore decline in total equity options average daily turnover, proprietary traders accounted for slightly more than half; retail investors accounted for 35%. Prop desks, in other words, were the swing factor in the market's August contraction. Average daily options turnover across India fell 20% month-on-month in August, according to Jefferies, the first full month since the auction was introduced, while some algorithmic traders said they cut activity by 35% to 40%.
Why the Auction Window Became a Liquidity Trap
The problem is not that auctions are a bad idea. Single-price closes are standard in developed markets precisely because they reduce the incentive to game the last trades of the day. The problem is that India's version was launched without the participant base that makes a single-price auction work. A closing auction needs market makers and prop desks willing to arbitrage away gaps between the indicative auction price and fair value. Those are the very players the RBI rule just made more expensive to run.
The result has been volatility that looks less like price discovery and more like a gap with no bridge. On 27 August, during the Sensex monthly options expiry, the indicative closing price for the 30-stock index plunged 3.3% during the auction window. Surat-based trader Rohit Tiwari said his loss ballooned to 380,000 rupees during the auction from about 50,000 rupees before it.
"My options positions are now much smaller and every trade is accompanied by additional hedging."
Tiwari said. He added that he also lost 200,000 to 300,000 rupees on Nifty's monthly expiry that week.
A week later, the same mechanism produced a wider intraday scare. On 3 September, during the weekly Sensex expiry, the benchmark's indicative close briefly slipped more than 2,100 points - a potential drop of about 2.5% - before the index recovered to close 0.55% lower at 76,152.86. Nifty 50 ended 0.17% lower at 23,873.45. Premiums on some Sensex put options spiked between 400% and 500% during the auction window, according to market data. The episode was severe enough to move the options market around it: open interest in Sensex put options surged as traders rushed to buy downside protection for the closing window.
For traders using margin against portfolios of stocks and bonds, the uncertainty has turned the final phase of the day into a blind bet. Nishant Rakesh, a Noida-based IT-company owner who trades on margin, said the period immediately before the auction, followed by the fluctuating price during the auction itself,
"can cause stop-loss and risk management measures to fail at precisely the point traders most need protection."
Quantitative firms are pulling back in step. QCAlpha Advisors has cut expiry-day volumes by 70% to 75%, particularly during the auction window, founder Tanmay Kurtkoti said.
"The major issue is opacity. I don't know whether the trades that I push during CAS will get executed."
Vishal Mehta, chief executive of market analytics platform MarketScanner, said he has cut options positions by 35% to 40%, because he cannot hold open positions after 3 p.m. without risking that stop-loss levels get bypassed.
"We can't have too many open positions after 3 p.m. IST because it opens us up to the risk that our set stop-loss levels can get bypassed."
Even on a day designed to showcase the system, the cracks showed. During the MSCI India Index rebalancing on 31 August, the closing auction processed a record ₹39,718 crore of turnover - roughly $4.1 billion - far above the roughly $128 million average on ordinary days. The event proved CAS could handle a concentrated burst of institutional flow. It also produced sharp, sometimes counterintuitive moves in individual stocks, suggesting the quality of closing-price discovery is still being tested.
The Regulator's Dilemma: Fix It Without Admitting It Is Broken
SEBI has said the closing auction is here to stay, but it is open to review for improvement. On 12 September, the regulator issued a consultation paper proposing to review the methodology for determining expiry-day settlement prices for both index and stock derivatives, adjust closing market timings, revise order handling and information dissemination, and stop displaying the indicative index value during the auction - a figure the regulator now says could be misinterpreted and influence position-taking. Public comments are due by 3 October. The options on the table include blending CAS prices with volume-weighted average prices, or reverting to the old model for a year before transitioning to a blended system. In a separate enforcement action, SEBI fined two firms ₹3.7 crore for CAS manipulation, a signal that the thin window is vulnerable to gaming.
In parallel, SEBI has tried to recruit a new source of liquidity. In the first week of September, communicated through the Association of Mutual Funds in India, the regulator temporarily allowed arbitrage funds to carry unhedged positions of up to 1% of assets under management during the closing auction. The category held a combined ₹3 trillion, or about $31 billion, at the end of August.
"Sebi has temporarily allowed arbitrage funds to have 1% of their AUM unhedged so that they can participate in CAS. This will help bring more liquidity to the closing auction session."
One official said, on condition of anonymity. Fund managers, however, doubt the concession will drive significant participation.
The two measures sit uneasily together. One hand is tweaking the auction's design because participation is too thin; the other is relaxing hedging rules to coax the one pool of money large enough to matter into that same thin window. If the arbitrage funds stay on the sidelines, SEBI is left with a choice it has not yet made: bring back some form of the old VWAP settlement on expiry days, or accept a permanently thinner close.
Cyclical Shock, Structural Shift
The right way to read this slump is to separate the cyclical leg from the structural one. The cyclical leg is the RBI collateral rule: it is a liquidity and funding-cost shock, and prop desks can adapt to it. They are already shifting from bank guarantees to non-convertible debentures, accepting higher funding costs to stay in the game. If SEBI eases the derivatives settlement methodology as proposed, some proprietary participation and volume should come back. D.K. Aggarwal, chairman and managing director of SMC Capitals, put it plainly:
"The funding curbs and CAS have played an equal role in reducing the market share of prop traders. While the curbs will continue to impact volumes on both exchanges, the revision in derivatives settlement currently under consideration could bring back some proprietary trading participation and volumes."
But the structural leg is the auction itself. Once closing-price discovery moves from a 30-minute average of actual trades to a single price set in a 20-minute window, the market's microstructure changes permanently. Liquidity concentrates in a handful of heavyweights - Reliance, HDFC Bank, TCS, Infosys - and the closing price gets discovered from a much smaller pool of orders than before. That is a regime change, not a teething problem. Even if props return in force, they return to a market where the close is an auction price, not a traded average, and where the cost of providing liquidity in that window is structurally higher.
The second-order consequence is where this story stops being about prop desks and starts being about everyone else. The cash-market auction now sets the settlement price for derivatives. When the auction gaps, options and futures P&L move with it - a microstructure change in the cash market is repricing risk across the entire derivatives book. Index funds and passive products that transact at the close now face execution prices that can sit away from continuous-trading values. And the divergence between the two exchanges' index closes - already observed in the auction's first month - is the visible symptom of price discovery fragmenting across venues. With prop liquidity thin, the closing price of a heavyweight stock is no longer a broad consensus; it is the clearing point of a smaller, more concentrated order book, and that concentration travels straight into the index levels that trillions of rupees of passive money track.
The Counter-Thesis, and What Would Break It
The strongest argument against a structural read is that this is simply a botched rollout, and rollouts get fixed. SEBI is already consulting on changes; the MSCI rebalancing showed CAS can absorb nearly ₹40,000 crore of flow in a single session; prop desks are adapting their funding and shrinking positions rather than exiting entirely; and the ₹3 trillion arbitrage-fund pool has just been handed a wedge into the auction. If participation returns and volatility normalizes over the next two months, August will look like a one-off transition cost, and prop share could drift back toward its pre-CAS level near 48%.
That case is coherent. It is also testable. The falsifying signal is the next two prints of NSE Market Pulse data. If proprietary share of equity options stays below roughly 46% for two consecutive months - September and October 2026 - even after SEBI's settlement-rule tweaks take effect, the slump is structural, not cyclical. A market that has re-priced the cost of its own closing price does not easily re-price it back.
What Comes Next
Three timelines matter here. In the short term, everything turns on SEBI's consultation window closing on 3 October and what the regulator decides on expiry-day settlement. A move toward a blended CAS-VWAP model would be read as a partial retreat and would likely lift near-term participation. In the medium term, watch whether arbitrage funds actually enter the auction in size - the 1% unhedged leeway is a permission slip, not an order. If the ₹3 trillion pool stays on the sidelines, the liquidity gap persists. In the long term, the question is whether India's close becomes a genuine single-price auction with deep participation, or a thin, manipulated-prone window that the regulator is forced to hybridize.
Base case: SEBI adopts a blended settlement model for expiry days, prop share stabilizes in the mid-40s rather than recovering to the high 40s, and the market accepts a structurally thinner, more expensive close. Upside case: the consultation produces market-maker incentives and clearer execution guarantees, arbitrage funds participate meaningfully, and prop desks return as funding costs normalize. Downside case: participation stays thin, manipulation fines multiply, and retail traders absorb wider slippage at the close as the cost of a reform that improved transparency at the price of liquidity.
The closing price of a stock is supposed to be the market's consensus on where value stood at the end of the day. India just changed how that consensus is reached, and the first lesson is that transparency and liquidity are not the same thing - you can have a cleaner price and a thinner market, and the prop desks that used to bridge the two are no longer being paid enough to show up.
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