Like all things in life, the markets too are not exactly black and white. Sometimes it’s green, the other times it bleeds red. Alongside these, there is a narrow domain which is in-between, unbeknownst to many – The Grey Market.

We have been talking about the stocks markets, IPOs, and what not incessantly in the recent years. Is it just the pandemic that has forced us to listen in on these conversations or has there been a sudden rush of financial literacy that has dawned upon us? Maybe a mix of both, and more.

There’s one more buzzword in these passionate conversations that might have caught your attention – The Grey Market. Let us try and understand the A-Z of it.

What is Grey Market?

So, how do we define this narrow domain called the grey market? Simply put, it is an unofficial market where goods are sold outside the official distribution channels.

For instance, if you have ever bought a branded shoe for a fairly less price than the MRP, you may have purchased it from the grey market. The goods here are sold by unauthorized dealers. It is however, an unofficial market but not an illegal market.

Similarly, grey market IPO is where individuals buy and sell IPO shares or applications even before they are listed on the stock exchanges. As an unofficial market, there are no rules and regulations. All transactions are mutually settled and none of the regulatory bodies like the Securities and Exchange Board of India (SEBI) or National stock exchange (NSE) and the Bombay stock exchange (BSE) are involved in these transactions.

 

What are the regulations around this Grey market? Is it part of the IPO market?

Since the trades in grey market are undertaken on the basis of trust, the counterparty risk very much  exists. Given that there are no regulatory bodies involved in the process, the trading is considered relatively risky too.

Whereas the IPO is an officially-recognized medium of raising funds in the market, as it is regulated by SEBI. Albeit the IPO’s primary market and grey market do not have any official connection, they perform similar functions to a greater extent.

The Grey market’s signaling mechanism inform various stakeholders of the demand for a specific IPO. It also has a high likelihood of being easily manipulated due to its fundamental nature.

Nobody has a record of the shares traded in the grey market and at what price.

Why do companies allow Grey market launches/trading, how is it beneficial to them?

Grey market trading happens, even before the company is listed. Many times, underwriters use trading on these markets to gauge and estimate correct IPO valuation. These markets help underwriters get an idea of demand and what could be the path for Company once it gets listed.

For the promoter of the company, grey market is a marketing expense where they gauge interest. It is equivalent to conducting focus group studies by big firms to analyze and understand the hype for a product before the actual launch. It’s a premature product cycle where a product is shares of the entire company itself.

Even if big investment bankers lose money in grey market because of high premiums, they are reimbursed by their promoters because (as mentioned before) it does not hold a fundamental intrinsic value for them due to low volume of shares traded and is more of a marketing stint. 

Also, there is at least a six-day delay prior to the listing of shares on stock exchanges. Since time itself is money, underwriters are anxious to begin selling and therefore, are willing to sell shares in the grey market.

 

What is Grey Market Premium (GMP)?

Let’s understand through a simple example.

Company A is soon going to launch its IPO and has revealed that the allotment price per share is INR 100. The grey market buyers are willing to pay a price of INR 125 for the same allotment. The difference of INR 25 is what the buyers pay over and above, which is called Grey Market Premium. 

Things to note about GMP are-

• Higher GMP generally indicates that listing is going to happen at a higher price. Thus, rewarding the applicants and grey market discounts indicate that the offer is likely to list at a lower price.
• The operation days of the grey market for a particular security is between the IPO start date and listing date. 
• The premium fluctuates on a daily basis and is an indicator of reactions in the secondary market.
• In general conditions, GMP usually goes up with wider markets and, takes a down road in weaker markets.

 

What is the Kostak rate?

The amount an investor realizes by selling his/her IPO application is called the Kostak rate. It is the amount the investor is set to receive irrespective of allotment status. 

FOr instance, a Kostak rate of INR 1000 indicates that the seller will receive INR 1000 even if the IPO is not allocated or the listing is at discount to it’s allotment price. 

 

What is Subject to Sauda?

Another term frequented by grey market investors is Subject to Sauda. It’s used to denote a sauda (trade) for buying a firm allotment application. In simple words, this is the amount one is willing to pay for an application that has been allotted to IPO shares. The amount involved here is much bigger than the Kostak rate. 

Things to note about Subject to Sauda are-

• The seller gets the amount even if IPO lists at a discount.
• The risk of listing price being lower than the allotment price is borne by the buyer.
•  In case of no allotment, the sauda is null and void.
• Buyer has a chance to earn big rewards in case of sauda, but earns nothing in case of no allotment; while in KOTSAK there is a definitive reward on selling the application.

The types of trading in a grey market setup

• Trading allocated IPO shares before they list on the designated stock exchanges.
• Trading IPO applications at a certain rate (premium).

Let’s understand each one of them with the help of examples.

Trading allocated IPO shares before they list on the designated stock exchanges

In general, Grey market allows investors to trade shares before official listing. As discussed earlier, this is done at a grey market premium. This market is an example of an over-the-counter (OTC) market setup.

Positive grey market premium

Let’s say the issue price of Company A is INR 100. Grey market buyers’ premium of A is INR 24. In this situation, there is a positive premium. Factoring in the positive premium, the buyers are willing to purchase the shares of A at INR 100 + INR 24 = INR 124.

Negative grey market premium

Let’s assume in this situation the grey market premium A is INR -30 (sellers). The issue price is INR 100.  Because the grey market premium here is negative, it indicates that the sellers are ready to sell the shares at a discount of INR 30. Hence, they are ready to sell the shares at INR 70.

The grey market premiums are considered to be indicators of the market trends but expert investors suggest that they should not be taken too seriously. The reasons are-

• Compared to regulated markets, the grey market is too small. The size is close to being insignificant and might not even be an indicator of true demand.
• Manipulations in grey market are more likely, as the markets are completely unregulated and unofficial.
• Factors such as fundamentals and economic trends which might dominate the direction of the stock are not factored in.
• Investors often use IPOs for profit-booking on the day of listing. Due to heavy selling, stock prices might even go below the issue price. If an investor invests purely on basis of the grey market premium, it might be a deal breaker.

Trading IPO applications at a certain rate (premium) 

The period between closing of the application window and allotment of IPO shares is used by traders to deal in IPO applications. In normal course, it is very rare for investors to trade IPO application post-allocation, as it would be better to trade IPO shares by then. The process works as follows:

• Each retails application is treated equally by allocation algorithm, hence buying IPO applications on the grey market acts as a way to increase the chances of share allotment.
• At the time of allotment, the seller will transfer all the shares allocated to the buyer, regardless of what the listing price is on the day of listing.
• In return, he/she accepts Kostak over the issue price on the spot.  Once again, nothing is issued by the grey market to indicate this sale.

 

What are the Income-tax implications of grey market trades?

Many people are unaware that the seller of grey market application is subject to taxation.

Since it is an unregulated market, all profits will be in the name of the IPO applicant who sold his/her application. Grey market trades are mostly settled in cash which results in actual transactions happening in the applicant’s account. This directly puts the tax liability on the applicant.

The seller must pay a short-term capital gain tax on the actual profit he made from selling stock market shares.

An extreme situation occurred on March 21, 2017, in the instance of the DMart IPO

• The IPO application for DMart was sold in grey market for INR 2500 (Kostak). Let’s pretend you’ve made a profit on your application.
• After all the times that the IPO gods have deserted you, this time you got lucky and were given 50 shares for INR 15,000 at a price of INR 300 per share (1 lot).
• DMart’s stock was floated for INR 650 on the first day of trading. You made INR 32,500 by selling the 50 shares.
• In your books, you made a profit of INR 17,500.
• Out of this profit, you will keep INR 2500 and have to pay INR 15,000 to your grey market dealer in cash.

Now here the tax issue comes up:

You will have to pay short-term capital gain tax (at 15%) on the total profit you made by selling the stocks, which is INR 17,500 in this case.

Your tax liability on this transaction is INR 2,625.

So overall, you lost INR 125 in this transaction.

Few common FAQs related to Trading in Grey Market

• Can I, as a retail investor 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.

• Who do I approach for buying or selling grey market shares?

As it’s an OTC market, there are no official people or businesses you can approach for grey market trading. If you are interested in buying or selling IPO stocks in grey market, you have to find a local dealer who can find buyers or sellers for you.

Grey market trading is mainly active in a few cities including most of the cities in Gujarat, Mumbai, Delhi, Jaipur etc. 

Closing notes

The grey market was a big hit amongst traders at the time of launch because most of the issues would just about be subscribed.

So, the traders could be assured of getting 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.

While the term ‘grey market’ and it’s promise of lofty returns may sound extremely fascinating and exciting, please be advised that the grey market is extremely risky and unregulated. And of course, most high potential rewards come at the risk of equally high risks.