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Explained: The IPO grey market - what it is, does it predict listing gains and can you trade it?

Explained: The IPO grey market - what it is, does it predict listing gains and can you trade it?

By CNBCTV18.com Jan 20, 2021 5:27:43 PM IST (Published)

With the market for Initial Public Offerings (IPOs) on a tear, there has been a lot of chatter about grey market prices of these shares. Here's everything you need to know.

With the market for Initial Public Offerings (IPOs) on a tear, there has been a lot of chatter about grey market prices of these shares from the time before the issue opens for subscription, till the day of listing. Here is a quick lowdown on the great market and how it functions.

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To start with, what is a grey market in IPOs?
It is the unofficial market for trading in shares of companies that have announced their initial public offerings, and will be getting listed on the stock exchanges shortly.
Is it a legal market?
No, it is not. You transact in a grey market at your own risk.
Why does a grey market for IPOs exist?
The grey market is kind of a signaling mechanism, and tells the market about the demand for a particular IPO. Because of its very nature, there is a good possibility that this market can be easily manipulated.
Nobody has a record of how many shares are traded in the grey market and at what price.
If the IPO is hugely popular, the grey market prices are usually a fair indicator of the demand for the issue. But if the company is not renowned, the investment banker to the issue will strike deals at prices which gives an impression of heavy demand for the IPO.
More often than not, the price at listing is close to that at which the shares are traded in the grey market.
How did a grey market in IPOs come about?
Back in the days when multinational companies had not yet gone public, most Indian promoters found it hard to raise money from the public through share offerings. So promoters and their merchant bankers hit upon the idea of a parallel market, wherein an impression could be created that the shares were worth far more than the price at which they were being offered in the IPO. Brokers backed by investment bankers would offer to buy the shares at a small premium in the grey market, and there would be traders willing to take up the other side of the trade.
Wouldn’t the investment bankers lose money by buying shares at a premium in the grey market?
The investment bankers would be reimbursed the losses, if any, by the promoter. For the promoter, the grey market premium was a marketing expense.
The grey market was a big hit with the traders of that time because most of the issues would just about be subscribed. So the traders could be assured of getting the full quantity of shares they applied for in the IPO. Traders would sell in the grey market at a premium, and buy an equivalent quantity of shares at a lower price in the IPO. The difference between the grey market price and the IPO price would be their profit.
I am a retail investor. Can I participate in the grey market?
In theory yes. But only if you know the market operators who offer quotes for grey market trades. The grey market is for professional traders, and you should be willing to transact in huge volumes to get an entry here.
Will my stock broker help me get an introduction to these operators?
No way! As mentioned earlier, the grey market is illegal, and is beyond the reach of the regulator. So your stock broker would certainly not risk drawing the regulator’s ire by being party to illegal trades.
Also, if you trade as an investor trade in the grey market and something goes wrong, there is no official body you can approach with your grievance.
How are the trades in the grey market settled?
Before the securities transaction tax (STT) came into effect in 2004, grey market trades would often be regularized by putting them through the stock exchange platforms. Also, when overall market volumes were low, you could match your trades with a particular counterparty with whom you had stuck an off-market deal.
But with the market now very liquid, and also with trading algos on the prowl, it is hard to match trades with a counterparty of your choice.
So grey market trades are settled in cash, with the reference rate being the pre-open price arrived at through the call auction process on the day of listing.
If you are long on an IPO at Rs 100 per share, and the pre-open price is Rs 125, your grey market broker will pay you Rs 25 per share. If it is the other way round, you have to pay Rs 25 per share to your grey market broker.
Considering that it is an unofficial market, are the trades honoured?
In an overwhelming majority of the cases, the trades are honoured, and that is why the grey market is alive and kicking even today. But there has been at least one instance of a major default. In 2008, many traders had heavily gone long on Reliance Power in the grey market, confident of making a good profit. But when the stock sank on listing, many traders reneged on their promise. That triggered a crisis of confidence in the grey market, resulting in a lull in activity for the next few years.
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