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As SEBI cracks down on the business of P-Notes and the tax department follows up on the use of cash for generating unaccounted incomes, it comes as a surprise that the grey market for shares thrives unfettered.  It is fairly common for major newspapers to quote the premium offered on the grey market following any Initial Public Offer (IPO).  Some important questions arise in this context - why do grey markets exist at all when there is a fairly well established method of price discovery in India, have there been changes in the rules of allotment that may have triggered such a response and why the income tax department as well as SEBI should worry about the existence of this market.


The grey market for IPOs has existed in India for a while. It is an active market with volumes that are fairly comparable to the official market.  India has a booming IPO market where the returns earned on the day of listing can be more than double of the issue price.  Krishnamurti et al. (2011) estimate that on the day of listing (in 2007-08), the return earned was 93 per cent. In another estimate, it has been found that 68 per cent of the IPOs listed at prices that assured a return to an investor higher than the returns earned over a year.  With such returns, the grey market fits in like a missing market that allows those bidding in an IPO to lock in the gains prior to the listing. The existence of the grey market therefore is predicated on the under-pricing of IPOs. The issue of under-pricing of IPOs has been treated at length by studies. As early as in the 1970s, Logue (1973) and Ibbotson (1975) raised this issue and the same has been dealt in detail in the context of different countries by subsequent studies such as Ritter and Welch (2002), Marisetty and Subrahmanyam (2009) and Hassan et al. (2010). Given that there is substantial evidence to support the under-pricing of IPOs, the brisk business in the grey market can be attributed to some extent to this under-pricing. 
To assess the problem it is important to understand the institutions involved in and the process of price discovery itself. In India, the underwriters appointed by a company can be an investment bank or a consortium of investment banks. The underwriter fixes the price band based on the feedback it receives from institutional client base and road shows. The price band once fixed is the offer price based on which investors bid for lots in that range of prices.  There are three categories of investors in an IPO-QIBs, retail investors and NII. To each a cap in terms of value of investment and allocation of shares has been prescribed. Further, in July 2009, SEBI allowed the issue of shares to anchor investors by the underwriter.
Parallel to the official market, there exists the over the counter market for pre-listing trade in IPOs. In this market there are two kinds of agreements.  One is the purchase or sale of the share in grey market at a premium fixed in the market through the matching of demand and supply. This premium changes on the daily basis. The other option is sale of share application at a fixed rate referred to in market parlance as Kostak.  This fixed value is earned irrespective of allotment of shares. The premium and the fixed value offered for recent IPOs have been substantial and the listing prices have mirrored the value offered for these unofficial trades. For example, the grey market premium offered for the recently concluded HUDCO IPO was INR 17-18 on the last day of trade. The share was offered at price INR 56-60 and listed at INR 73. Similarly, D-mart listed at INR 604, where the IPO was priced between INR 290 and INR 299, and the premium was 235-240. While there have been exceptions such as Reliance Power, the trading premium in the grey market predicts, even if not perfectly then closely the listing price.  Once an application is sold, the investor receiving such allotment is to retain his return and pay the remaining gain in cash to the dealer in the grey market. In case, the gain made on listing is less than what has been paid to the investor selling the application the investor gets the amount promised. Although this amount is broken down so that the amount of gain as per listed price is realised through the stock market and remaining is paid by the dealer in cash. The short-term capital gains tax and brokerage are all borne by the seller.
While on the one hand, there exists a detailed process of price discovery on the other there exists grey markets. The gap in the prices allows one to question if there is something amiss in the process of price discovery. Studies such as Chang et al. (2015) attribute this to asymmetric information. That is, the full extent of demand for shares may not be captured when the underwriter is to set the price band for the shares. The anchor investors are expected to create interest in a particular IPO, but as it seems their bid and appetite for the IPO is not a true reflection of the demand. If that is so, there is a case for a pre-IPO market that may be able to deal with such pricing distortions that pave the way for grey markets.  Such markets exist in UK (alternative stock market) and Taiwan (emerging stock market). A company is allowed to list on this market prior to the IPO.
In trying to find why the issues are under-priced it is found in studies for countries other than India (Loughran and Ritter, 2002; Reuter, 2006; Nimalendran, Ritter and Zhang, 2007; and Goldstein, Irvine and Puckett, 2011) that “self-interested underwriters have strong incentives to bias the price down so that they can allocate under-priced shares to their favoured clients in exchange for side payments”. Such self-interest can be realised if the rules of allotment lack transparency. While in the US, the allocation of shares rests with the underwriting investment bank, which has been said to breed corruption in allocation (Nimalendran, Ritter, and Zhang, 2007; Liu and Ritter, 2010). In India, SEBI prescribed disclosure of allotments made to anchor investors.  Further, in 2012, SEBI changed the rules relating to the allotment of shares in the category of retail investors. For over-subscribed IPOs where the number of investors exceeded the designated lot of shares, the allotment process was to follow a lottery system.  It is expected that the sunshine requirement makes the allotment to the anchor investors a relatively transparent process. As for the retail investors, given the discontent with the lottery based allotment to retail investors in over-subscribed issues, the allotment process creates an incentive to sell the application through an off-market trade for an assured return.  Therefore, the existing functioning of the markets and the rules in some way work as useful aides to the grey market.
The reasons for the success of grey market can be attributed to the flaws in the existing rules and the process. The pricing and the process of allotment make the sale of application in the grey market lucrative. The functioning of grey market rests on the use of cash. The fact that all settlements are carried out through  and yet has not attracted any scrutiny is unsettling. Though the capital gains tax are paid in full, the fact is that it is borne by the retail investor, thus the broker offering the return on grey market ends up paying nothing. Therefore, even though on a gross basis there is no evasion, the broker is technically evading tax and is perpetuating the generation of unaccounted incomes. The fact that the broker is willing to pay a fixed return knowing that the price fixed in the grey market may not be realised is a reflection of two things - deep pockets and higher certainty of returns thereby making the case for controlling such activities.
1. Chang, Chun, et al., 2017. "Pre-market trading and IPO pricing." The Review of Financial Studies, 835-865, March 30.
2. Goldstein, M. A., Irvine, P., Puckett, A., 2011. Purchasing IPOs with commissions. Journal of Financial Quantitative and Analysis, 46: 1193-1225.
3. Krishnamurti, Chandrasekhar and Thong, Tiong Yang and Ramanna, Vishwanath, 2012. Grey Market for Indian IPOs: Investor Sentiment and After-Market Performance. Financial Markets & Corporate Governance Conference. (August 14, 2011). Available at SSRN: or
4. Liu, X., Ritter, J. R., 2011. Local underwriter oligopolies and IPO underpricing. Journal of Financial Economics, 102: 579-601.
5. Ljungqvist, A., 2007. IPO underpricing. B.E. Eckbo (ed.), Handbook of Corporate FinanceNorth-Holland.
6. Loughran, T., Ritter, J. R., 2002. Why don’t issuers get upset about leaving money on the table in IPOs? Review of Financial Studies, 15: 413–43.
7. Ritter, J. R., 2011. Equilibrium in the initial public offerings market. Annual Review of Financial Economics, 3: 347-374.
The author is Suranjali Tandon, Consultant at NIPFP, New Delhi.

The views expressed in the post are those of the author only. No responsibility for them should be attributed to NIPFP.

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