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No matter how promptly you pay your broker after your buy order is executed, you get your shares only after settlement on the stock exchange. But, what if the counterparty seller does not deliver the shares? Since you don't have the shares, you cannot book profits if the share price moves up. If your intention was to make a long-term investment, you would have to buy again at the higher price, with the difference being your loss. Stock exchanges guard against such eventualities by carrying out auctions.
An auction is the exchange's mechanism for getting shares for the buying broker in case of a default by the selling broker. This default could arise due to non-delivery (or partial delivery) of shares, or delivery of bad shares. It occurs when a short-seller (a speculator who sells shares that he doesn't own) fails to square up his transaction within a trading cycle, or a seller fails to deliver the shares on time.
On the National Stock Exchange (NSE), a separate auction trading session is held on Wednesday (commencing at 4:45 p.m.), the settlement payout day, or on Thursday. On the Bombay Stock Exchange (BSE), the auction session starts at 1 p.m. on Monday, its payout day.
The process. On the NSE, the clearing corporation draws up the list of shares not delivered by brokers at the end of the pay-in day, which is sent to all brokers on the auction day. Brokers get 30 minutes (termed Solicitor period') to place sell orders. They can offer their own shares, as well as their clients'.
Unlike regular trading, where order matching is a continuous process, orders placed during the auction session are matched at the end of the solicitor period only. The matching is based on the price-time priority principle; the lowest-priced sell orders entered earliest are matched against fixed buy side quantities. Auction prices are subject to a price band.
On the BSE, however, sell orders are continuously solicited. After an hour-and-a-half, trades are matched on price (though not on time priority since orders are not time-stamped). Trades are allocated between orders, with the same best price, at the exchange's discretion.
On both exchanges, selling brokers have to deliver shares within two days of the auction day. They receive payment on the auction payout day (Saturday on NSE, Wednesday on BSE), and the shares are passed on to the original buying broker. If the auction price exceeds the original traded price, the defaulting broker has to pay the difference, along with a penalty amounting to 0.05 per cent of the transaction value, to the clearing house.
Suppose you bought a share for Rs 100, which the selling broker failed to deliver. Another broker offers the share for Rs 112 at the auction. The clearing house gets Rs 100 from you, and pays Rs 112 to the successful broker. It recovers the difference (Rs 12) and the penalty (5 paise) from the original defaulter. Had the auction price been Rs 90, the clearing house would have gained Rs 10, which goes to the exchange's investor protection fund.
Buyer will get compensation. But, what if the shares don't come in during the auction session? This happens rarely: on an average, there are no sell offers for about 1-2 per cent of the shares put up for auction. In such a case, the transaction is settled at the highest recorded price between the relevant trading period and the auction day, or at 20 per cent above the last closing price, whichever is higher. The defaulting seller pays the difference between the original transaction price and the settlement price. As a buyer, you don't lose the amount paid for buying the shares, or miss out on any post-purchase price rise.
Opportunity for sellers. The auction process also offers an investor the opportunity to sell shares at rates above the prevailing market price (auction prices are usually 2-15 per cent higher), and realise gains within three to four days. Track the auction list, available with your broker, and place a sell order. If your order is accepted, you will have to deliver the shares to your broker within a day or two.