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Have you ever noticed stocks with bizarre price movements or abnormally high trading volumes? It could be due to circular trading – an unethical scheme used by some traders.
Circular trading creates artificial trading activity without any real change in ownership. Regulators view this as illegal because it distorts the market and misleads regular investors.
So, what exactly is circular trading and how to steer clear of this type of trade by spotting it early? Let’s find out!
What is circular trading?
Suppose a broker enters sell orders for a particular quantity of shares at an agreed-upon price and time, knowing that opposite purchase orders for the same number of units at the identical price have been or will be submitted. This practice is known as circular trading.
In circular trading, at the end of each trading session, the shares circle back to their original owners, even though there are several participants and transactions. Because of this, the number of transactions goes up without any change in ownership.
Such a trading system does not alter the owner of the securities. Circular trading generates inflated volumes to prove a security’s liquidity, keep the share price where it needs to be, and indicate investor interest in the stock. In many nations, the practice is prohibited and unlawful.
Circular trading example
Suppose brokers A, B, and C decide to inflate the stock price of “XYZ Corp.” Broker A sells XYZ shares to B, who then sells them to C. Finally, C sells them back to A just before the market closes.
Throughout the day, A, B, and C trade XYZ shares among themselves, keeping the price consistent. This method doesn’t change their ownership but increases the stock’s trading activity. As XYZ’s apparent activity spikes, it catches the market’s attention, creating a buzz. Unsuspecting investors start buying XYZ shares, driving the price up.
For example, the Enron incident served as a specific instance of circular trading in the early 2000s. Round-trip trading was a tactic employed by Enron in which trading partners were engaged in the purchase and sale of energy contracts. There was no gain or loss because the contracts were sold and purchased at the same price.
By hiding losses and inflating revenues, this tactic was employed to give the impression that the business was more lucrative than it actually was.
How to detect circular trading?
Although detecting circular trades is difficult, here are some ways you can be cautious as a trader:
Recurrent trading: Keep an eye out for the same stocks being traded often by a select few traders.
Unexpected volume increases: Watch out for sudden spikes in trading volume that coincide with little to no changes in stock ownership.
Price inflation: Circular trading is a possible explanation for a stock’s seemingly irrational price increase.
Circular trading in the stock market: Is it illegal?
Some people believe that circular trading is legitimate, while others believe that it is an illegal version of insider trading. The practice of purchasing or selling assets using significant, non-public knowledge is known as insider trading.
Trading using inside knowledge is against the law since it corrupts the market and provides traders with an unfair edge. But in circular trading, the same securities are bought and sold again and again by the same party or parties.
Circular trading is defined as unlawful or unethical trade conduct under the 2003 SEBI Regulations (Prohibition of Fraudulent and Unfair Trade Practices Relating to the Securities Market).
It is against the law for two people to fraudulently trade in the same security many times to inflate its price by making it seem like there is more demand than there is. The term for this kind of transaction is a “pump and dump” scheme.
Restrictions on circular trading in India
Unfair trade practices, including circular transactions involving securities, wherein intermediaries engage in them to enhance their commission, create the illusion of trading in such securities, or trigger price volatility, are considered fraudulent by SEBI.
On an individual basis, SEBI levies fines on brokers and entities found to be engaging in circular trading. Based on the degree of anomaly that was committed, the penalties might range from a penalty to an extended period or refraining from trading completely.
The Securities and Exchange Board of India (SEBI) has ordered all stock exchanges to set daily price bands and weekly limits for each stock to discourage circular trading and strengthen market stability. Each security now has a dynamic price range determined by the stock exchanges.
The exchanges have implemented a system to track fluctuations in volume and price or any signs of market manipulation, such as fabricated trades or circular trading.
Conclusion
Circular trading poses a serious threat to the fairness and transparency of stock markets. As an investor, staying informed about circular trading red flags and being wary of unusual price or volume movements can protect you from such manipulative schemes.
FAQs
Circular trading involves a group of traders who collude to trade stocks among themselves to manipulate the market. This practice creates artificial trading volume and can affect stock prices. On the other hand, wash trading is carried out by a single trader who buys and sells the same securities to create false market activity. Both practices are illegal and considered forms of market manipulation.
While circular trading is illegal, those engaged in it may do so to artificially inflate a company’s turnover, secure larger loans, and manipulate stock prices for personal gain. They may also use it to claim fake input tax credits. However, these are not legitimate benefits but fraudulent activities that can harm other investors and the integrity of the financial markets.
Insider trading involves trading based on non-public, price-sensitive information by individuals who are insiders of a company. In contrast, circular trading is a form of market manipulation where traders conspire to create artificial trading volume and influence stock prices. While insider trading is about the misuse of confidential information, circular trading is about creating false market activity.
According to the Securities and Exchange Board of India (SEBI), an insider is a person who is either a ‘connected person’ or has access to unpublished price-sensitive information (UPSI) about a company. This could include employees, directors, or any individual in possession of such information, which they could use for trading the company’s securities.
A pump and dump scheme is a fraudulent strategy where individuals or groups ‘pump’ up the stock price by spreading false or misleading information, then ‘dump’ their shares at the inflated price, profiting at the expense of other investors. This practice is illegal and considered market manipulation, as it deceives investors and disrupts the fair functioning of the financial markets.