SEBI has informally relaxed rules governing arbitrage mutual funds, giving them greater flexibility to manage their cash and futures positions. The move is aimed at encouraging arbitrage funds to participate more actively in closing price auctions on stock exchanges. Arbitrage funds exploit price differences between cash and derivatives markets; tighter rules had reportedly limited their auction participation. The relaxation is said to be communicated informally to fund houses rather than through a formal circular.

Arbitrage funds are a category of hybrid mutual funds that profit by simultaneously buying a stock in the cash (spot) market and selling an equivalent futures contract, locking in a price differential. They are taxed like equity funds if at least 65% of the portfolio is in equity and equity-related instruments, making them attractive to investors in higher tax brackets compared to debt funds.

India's stock exchanges conduct a Closing Price Auction session — typically in the last 15 minutes of trading — where the official closing price is determined. This mechanism, similar to international practices, requires sufficient liquidity from participants to function efficiently. When arbitrage funds face rigid position-matching requirements, they pull back from this session, reducing liquidity and potentially distorting closing prices.

SEBI's informal relaxation likely relates to allowing arbitrage funds to carry unhedged or temporarily mismatched positions during the auction window without breaching regulatory norms. This is significant because SEBI mandates that arbitrage funds maintain hedged positions — each cash-market purchase must be offset by an equivalent derivatives sale. Any relaxation in timing or matching requirements directly helps funds participate in the closing auction without regulatory risk.

From an exam perspective, this event sits at the intersection of mutual fund regulation, market microstructure, and SEBI's role as market regulator — all high-frequency testing areas.