India's market regulator has given arbitrage mutual funds more flexibility in managing their positions, seeking to draw liquidity into the struggling closing auction for stocks, according to people familiar with the matter.

The Securities and Exchange Board of India has allowed these funds to temporarily carry unhedged positions of as much as 1% of their plans. Arbitrage funds held a combined 3 trillion rupees ($31 billion) in assets at the end of August. The relaxation aims to bring liquidity into an auction that has struggled to attract enough players since its launch on Aug. 3.

Arbitrage funds profit from price differences between cash equities and futures markets, but requirements that they remain fully hedged made participation difficult. The auction shortened the window for stepping in and increased the risk of temporary mismatches. The new allowance lets funds carry that mismatch instead of staying fully hedged. SEBI on Saturday also proposed sweeping changes to the closing auction framework, including a possible return to the previous method for settling derivatives on expiry days.

AMFI communicated the relaxation to asset management companies earlier this month. Representatives for SEBI and the Association of Mutual Funds in India didn't respond to emails seeking comment.