Understanding IPO Grey Market: If you’re actively involved in the market, you might have come across the terms White market, Black market, and surprisingly Grey market. A white market is one that is considered a legal, official, and authorized market for goods. A black market is a complete opposite which is illegal.
A grey market, on the other hand, stands for a market that exists with the knowledge of the owner of the goods but takes place outside the official channels of exchange. Today we have a closer look at the IPO grey market.
An IPO is a means for the company to raise capital for its growth and expansion needs. For the investor, it may be an opportunity to make a quick move into owning the shares of a fastly growing company. The purchase of these shares generally takes place through authorized mediums which is the stock market regulated by the SEBI.
What is an IPO Grey Market?
A successful IPO generally has all its shares subscribed or oversubscribed. In cases of oversubscription, the shares are allotted on a pro-rata, or in cases where the subscription is too high a lottery system is adopted. Here the chance of an allotment is too low. In these situations, investors turn to the grey market for prospective sellers who have also applied for allotment.
When the IPO gets sold through unofficial or unregulated markets it is known as a Grey IPO market.
The Grey Market generally involves a seller, buyer, and dealer.
- The Seller is the person who actually takes part in the application for shares with the motive of selling them in the grey market.
- The Dealer acts as a mediator between the buyer and the seller.
- The Buyer is the person who purchases the allotted or unallotted shares in the IPO from the grey market
It is necessary to note that there is no regulatory body governing the Grey Market. All the agreement transactions that take place are on the basis of mutual trust placed on each other.
Timeline of an IPO
When an investor attends the IPO through the white market, he/she applies and bids on the day the IPO opens. The process of allocation of shares generally takes around ten working days. It takes two weeks for the shares to get listed and start trading after the closure of the IPO.
When an investor involves himself in the grey IPO market, the trading can start before the IPO begins and even after the allocation is done.
How does a grey market function?
In a grey market, the trading is done through a dealer or a mediator.
— Depending on the demand and conditions in the market the Grey Market Premium is set. The Grey Market Premium is the amount in excess of the offering price ( offering price is the price at which the company sells shares to investors in an IPO).
— The buyers who are willing to purchase it at this price make a deal with the mediators. The mediator, in turn, contacts the seller. The bids by the buyers can take place before the application even happens or even after their -allocation.
— The shares then get allocated to the seller. As soon as the shares are listed, on the direction of the buyer, the mediator may instruct the seller to transfer the shares to the buyer’s Demat account. Or he may request that the shares be sold in the stock market on the settlement price and transfer the sales proceeds to the buyer.
In the case where one of the party defaults there is no action that an individual can take as there is no regulatory body to monitor the transactions and all the transfers take place online.
Kostak and Kostak Price
In the grey market, it is possible for a person to have his ‘Application for the IPO’ be sold. The buyer will pay a price called the Kostak price in return for the seller promising his IPO application to the buyer.
It does not matter if the application gets allocated or not. Irrespective the buyer will have to pay the Kostak price to the seller.
Benefits of taking part in the Grey market
The main benefit the buyers acquire is the increase in their chances of allocation of shares in cases of subscription. It generally takes up to 2 weeks from the closure till the shares get listed. The buyers in the Grey market bet on the fact that the prices will be higher on a listing day in comparison to the unofficial price (inclusive of the grey market premium) from the Grey market.
The Buyer can then sell this at a higher settlement price once the stocks are listed and make a profit. On the other hand, the buyer also faces the risk of a potential fall in the price which may result in a loss.
Example: ABC company sets the offering price at Rs. 150per-share.
- Based on the demand for the shares of ABC the Grey market premium is set at Rs. 30.
- In this case, the total official price comes up to Rs 180.
- If the settlement price on the listing day is set at Rs.200 then the buyer is set to make a Rs. 20 profit.
- On the other hand, if the settlement price on the opening day is set at Rs. 160 then the buyer makes a loss of Rs. 20.
Taking into consideration Kostak.
In the same example as above for ABC company say the Kostak price is set at Rs.100 and a single lot size is of 100 shares. The application by the seller has been for one lot.
- In the above case say the price is set at Rs. 200.
- Here the seller will sell the lot and transfer the gain to the buyer’s account. The profit here is 20(200-180) x 100 =2000.
- From this amount Rs. 100 is deducted for the Kostak amount owed and the net gain is transferred to the buyer in exchange for the risk he took over.
- Similarly in the above example if the settlement price is at Rs.160 the buyer will face the loss of the price falling below the unofficial price and Rs 100 added from the Kostak price.
In the case of the seller not receiving an allotment for his application, the buyer will still have to pay him Rs. 100.
The buyer will also face a loss if the seller application does not get allocated. Hence in order to reduce the risk of non-allocation he creates an agreement with many sellers. Say if the IPO is oversubscribed by three times he then creates an agreement with multiple sellers he reduces the chances of loss because of Kostak price due to non-allocation.
The Grey market also serves the function of giving other investors an idea of the demand the shares of a company might have and the investor may adjust his application accordingly. The demand may also indicate a price at which the shares may trade once listed.
The Grey market may also be used by the company or the underwriter to push up the demand for the shares. Hence before using the Grey market as a reference, it should be noted that they are subject to manipulation. In addition, the stock market is a risky enough place. The grey market only adds to the risk due to the lack of a regulatory body and because the risk of trust cannot be quantified.