Auction

In the stock market, investors have different trading options like pledging shares with brokers, short selling, or using them as collateral. These options come with risks and can lead to financial losses if transactions aren't completed. To keep the market fair, exchanges like NSE or BSE start an auction process. This ensures that transactions are resolved fairly, especially when buyers or sellers can't fulfil their obligations.

Let us understand auction trading in detail, see the primary reasons that trigger the auction process, and learn it through simple steps.

What is auction trading

Auction trading of securities is a process designed to address situations of:

• Payment defaults or
• Short delivery of shares

When a seller fails to deliver shares on the designated delivery date, the exchange, such as the NSE or BSE, steps in to manage the situation. We will understand this process later. For now, let us study the two primary scenarios that trigger share auctions in the equity segment:

Scenario I: Failure to fulfil pay-in obligation

Meaning

• This situation arises when an investor has sold shares but fails to meet the pay-in obligation on the agreed-upon delivery date.

Reasons

• Several factors can lead to this failure, such as:
  • Errors in the delivery process (like discrepancies in the delivery slip) or
  • If the shares were pledged as collateral or for meeting margin requirements

Hypothetical example

• Suppose an investor decides to buy shares of ABC Company through his broker.
• The transaction is executed.
• They are expected to deliver the shares to the buyer on the agreed-upon delivery date.
• However, they fail to do so.

Let us see how the two possible reasons can occur:

Scenario II: Short delivery of shares

Meaning

• Short selling refers to selling shares the seller does not own.
• This is usually done with the intention of buying them back at a lower price in the future.
• The situation of short delivery of shares arises for traders who have:
  • Taken a short position on a stock but
  • Failed to close the short position within the same trading day

Example

• Mr. A, a trader, believes that the stock price of XYZ Company is:
  • Overvalued and
  • Likely to decrease in the near future
• Without actually owning any shares of XYZ Company, Mr. A decides to engage in short-selling.
• Mr. A instructs his broker to sell 100 shares of XYZ Company.
• Contrary to Mr. A's prediction, the stock price of XYZ Company begins to rise unexpectedly by the end of the trading day.
• As the stock price increases, Mr. A faces losses in his short position.
• Mr. A fails to close his short position within the same trading day.
• This failure can happen due to various reasons, such as:
  • Market conditions
  • Technical issues, or
  • Lack of available shares to purchase
• Consequently, Mr. A is unable to deliver the shares of XYZ Company to the buyer within the agreed timeframe.

It must be noted that auction trading applies to commodity trading as well. In the commodities market, it is initiated by the Multi Exchange Commodity (MCX).

What happens during an auction in a share market

During the auction trading process:

• The exchange facilitates the buying and selling of the shares that were:
  • Not delivered or
  • Not covered due to short delivery
• Bids are submitted by interested parties.
• The auction mechanism determines the winning bid based on specified criteria, such as price limits.
• The exchange then ensures that the shares are delivered to the buyer, completing the transaction and fulfilling the obligations of the seller.

Let’s understand this process in simple steps

Step I: Initiation of auction trading process

• The exchange initiates the auction process when a seller fails to deliver shares on the agreed-upon date.

Step II: Notification and participation

• The exchange notifies member brokers about the upcoming auction.
• This intimation is usually given through various channels, such as its website or other communication media.
• Interested brokers choose to participate in the auction.

Step III: Auction period

• The auction typically takes place on:
  • The T+2 day
  • Between 2 P.M. and 2:45 P.M.
• During this period, brokers submit bids for the shares in question.

Step IV: Bid limits and criteria

• The exchange imposes bid limits.
• It sets upper and lower bounds for the bidding process.
• Bids cannot exceed a certain percentage (typically 20%) of the T+1 day’s closing price.

Step V: Auction outcome

• The exchange evaluates the bids received.
• It determines the winning bid, usually the highest one within the prescribed limits.
• The exchange purchases the shares from the winning bidder.
• It delivers them to the buyer.

Step VI: Completion of transaction

• Shares are delivered to the buyer on the T+3 day.
• With this delivery, the transaction gets completed.
• The auction process comes to an end.

What happens when sellers are not found in the auction market

In cases where fresh sellers are not found in the auction market, the exchange resorts to a process called "close out." Following this process,

• The settlement of a trade is done in cash
• No shares are delivered to the buyer

The exchange settles the transaction by compensating the buyer at a “close-out rate”. This rate is determined by choosing the higher value between these two options:

1. The highest price of the scrip in the exchange from the trading day until the auction day for the shares that were short-delivered.
2. A price that is 20% higher than the official settlement price on the auction day.

Conclusion

Auction in the share market is a process initiated by the stock exchanges, such as NSE or BSE. It helps in resolving payment defaults or short delivery of shares and ensures the completion of transactions. Auction share trading plays a crucial role in maintaining market integrity and stability.