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In the market, the legitimacy of a trade depends on the bid-ask process. Trading platforms, along with market makers, consider the demand and supply of stocks to decide on the trade price at which the trades are required to be settled between the counterparties. But what if the price fixation is directly between the counterparties without the involvement of market makers? Are such deals legal? Most importantly, what is the term used for such trades?
Let’s discuss all this in this article.
Pre-Arranged Trading — Definition
Pre-arranged trading is a financial practice where market participants agree on the terms of a trade, including price and quantity, before executing the transaction. This method is often available in markets where trades are not conducted through a central exchange, such as over-the-counter (OTC) markets.
Pre-arranged trading allows traders to manage risk by locking favourable prices and conditions to their investment strategies.
What is Conditional Order?
A conditional order is a type of pre-arranged that works by setting triggers based on the trader’s specified criteria. These triggers could be as simple as a stock reaching a particular price or as complex as a combination of volume, time of day, and market indices. When the order conditions are met, the trade is automatically executed. This approach provides a trader with a strategic tool for managing market entry and exit points.
Conditional orders are adaptable and can include different types, such as limit orders, stop orders, stop-limit orders, and contingent orders.
How does Conditional Order work?
Suppose a trader wants to buy X Company shares. He believes that the current market price is too high and expects the company’s upcoming earnings report to be favourable and increase the stock price. To capitalise on this scenario, he sets a conditional order to acquire 1,000 shares of Company X if the price drops to Rs 50 per share before the earnings report is released.
Here, the conditional order acts as a safety net. It ensures the trader pays no more than Rs 50 per share.
What is Block Order?
A block order is a large and privately negotiated securities transaction arranged outside of the open public markets. The purpose of privately arranging such trades is to lessen the potential impact on the security’s price. Institutional investors, such as hedge funds, usually carry out these trades via investment banks and other intermediaries.
Block trades are usually split into smaller orders and implemented through different brokers to mask the correct size of the trade. This is done to prevent other market participants from reacting to the trade, which could affect the market price unfavorably for the trader initiating the block order.
How does Block Order work?
Imagine a hedge fund, XYZ Capital, that wants to sell shares of a small-cap company, ABC Corp, in bulk. The current market price of ABC Corp is Rs 10 per share, and XYZ Capital wants to sell 100,000 shares. If executed as a single market order, this sale could significantly push down the price of ABC Corp shares because of the sudden increase in supply.
To avoid this, XYZ Capital decides to arrange a block trade. They contact an investment bank, which acts as an intermediary, to find a buyer willing to purchase the shares at a mutually agreed price, slightly below the market price, say Rs 9.95 per share.
Is Pre-Arranged Trading Illegal?
In India, pre-arranged trading is considered illegal when it involves market makers exchanging securities at predetermined prices for their own benefit. The reasons for making such trades illegal are as follows.
- Pre-arranged trades can lead to a lack of transparency. This obscurity can affect the fair valuation of securities and may not reflect the true market conditions.
- Pre-arranged trading can sometimes lead to collusion among participants. They might agree to execute trades at certain prices to their mutual benefit, which is illegal and undermines the competitive nature of the markets.
- Since these trades are agreed upon outside the open market, they do not contribute to the market’s liquidity. This can lead to reduced trading volumes and may impact the ability of other market participants to execute trades efficiently.
- Pre-arranged trading often involves large institutional investors, which can exclude smaller investors and traders from benefiting from certain market opportunities.
How is Pre-Arranged Trading Different from Pre-Market Trading?
Many investors use pre-market and pre-arranged trading interchangeably. But they differ from one another in every aspect. Here are the distinctions in tabular format.
| Parameters | Pre-Arranged Trading | Pre-Market Trading |
| Definition | Pre-arranged trading involves counterparties agreeing on the price and terms of a trade well in advance. | Pre-market trading means the trading transaction that occurs before the regular market session begins. |
| Legality | It can be illegal if market makers facilitate securities exchange at pre-arranged prices. | It is a legal and routine practice initiated by NSE and BSE in October 2010. |
| Purpose | Used to set a specified price for execution, often for large orders. | Allows investors to react to global or domestic news and events outside of regular trading hours. |
| Timing | It can occur at any time when parties agree to the terms. | Occurs during a specific window before the market opens, usually from 9:00 AM to 9:15 AM. |
| Participants | Typically involves institutional investors or large traders. | Open to all eligible investors. |
| Volume | Generally involves high-volume trades | It can have thin liquidity and low trading volumes. |
| Price Discovery | Price is determined by the parties involved and may not reflect market conditions. | An automated system assesses demand and supply to establish an opening price. |
| Market Impact | It may not directly affect the market as it is a private agreement. | It can influence the opening prices and initial market direction. |
| Risks | Risk of regulatory scrutiny and potential market manipulation | Risks include volatility and less reliable pricing due to low volume |
Conclusion
Pre-arranged trading is a strategic approach in which traders agree on trade terms beforehand. It helps them manage risk and ensure favourable conditions. The two common pre-arranged trading examples are conditional orders and block deals. The former set triggers for automatic trade execution based on specified criteria, while block orders facilitate large transactions outside public markets to minimise price impact. While pre-arranged trading can be illegal if misused, it differs from pre-market trading, which allows investors to react to news before regular trading hours.
Frequently Asked Questions
Pre-arranged trading refers to the practice of market participants agreeing on the price and terms of a trade before it is executed. This can involve conditional orders on exchanges or over-the-counter (OTC) trades. Pre-arranged trading is a way to manage risk and ensure a specific outcome for the trade.
The main benefits include reduced market volatility, price certainty, and efficient capital allocation. It allows traders to avoid price fluctuations and ensures that large orders do not disrupt the market. It also helps in managing liquidity and counterparty risks.
Risks include a potential lack of market transparency and the possibility of market manipulation. Regulatory compliance is also challenging, as pre-arranged trades must adhere to stringent guidelines to maintain market integrity.
Pre-arranged trading is common with stocks, futures, options, and commodities, especially when these securities are not frequently traded on the leading exchanges.
Institutional investors, large traders, and market makers in OTC markets are the typical users of pre-arranged trading. They use it to execute large transactions without causing significant price movements in the market.