What Is an IPO Grey Market?

Companies that plan to launch an IPO, generally decide to test waters in the grey market. They do so for various reasons such as to check the demand for the impending IPO or to gauge what the IPO valuation should be.

This unregulated marketplace was established to trade stocks waiting to be listed on larger exchanges or to trade those unable to qualify for the big exchanges.

Not every stock is associated with an IPO. Some grey market stocks are issued by start-up or spin-off companies looking to test the waters before spending the time and money to be listed on a major exchange.

There might also be stocks which at one point traded on the big, recognized exchanges but have since suffered financial misfortunes or failed to meet Securities and Exchange Commission requirements.

Although grey markets are not illegal, they are not authorized or controlled in the usual way. That means SEBI, stock exchanges and brokers are not involved or back these transactions taking place in the grey market. Therefore, there’s little legal recourse available to parties if the stock tanks.

The grey market is an over-the-counter market where dealers may execute orders for preferred customers as well as provide support for a new issue before it is actually issued.

This activity allows underwriters and the issuer to determine demand of the company. This helps them get a sense of what the IPO valuation can be.

The grey market avoids advertising and frequent trading activity records cannot be found either. In many cases, stocks on the grey market are too new to have histories.

How Does an IPO Grey Market Work?

An IPO grey market allows investors to bid on shares of a company before its initial public offering (IPO). It operates as an unofficial platform that provides an indication of the expected listing price and demand for the IPO.

In the grey market, brokers buy shares from employees and early investors of the company and then sell these shares to other investors before the official listing. The trading price set in the grey market acts as a reference for investors to gauge the potential price when the IPO opens for public subscription. However, the grey market does not involve the company itself issuing new shares.

The legality of IPO grey markets varies across different countries. While they can help discover a company's true valuation, lack of regulations also makes them risky for retail investors. The prices in the grey market may be highly volatile and not fully reflective of the demand.

Why People Trade in Grey Markets

Grey markets have been existing for a long time and many investors and traders vouch by it. That’s because it can be an excellent opportunity for retail investors and traders to purchase the shares before they are listed, if they feel that the stock is going to increase in value. It is pretty much a demand and supply situation.

Another reason is that if a customer wants to exit the IPO even before it is listed, the grey market provides them a way out.

It also allows people to buy IPO shares even though they missed the application deadline or if they want to buy even more shares than the IPO application could provide them with.

Why Companies Allow Grey Market Trading

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

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

How To Gauge the Grey Market IPO

There is no definite answer to this question. The way to handle this is to not jump in immediately. Instead, let other people trade and before you check the pricing. However, since the market is unregulated, detailed information is also not available many times.

How Are Grey Market Trades Settled?

Grey market trades are settled between brokers and investors directly, unlike the actual stock market where trades are settled by the clearing corporation.

When an investor places an order to buy shares on the grey market, the broker will source the pre-IPO shares from employees or early investors and deliver them to the investor while receiving payment in return. The entire settlement happens outside of the stock exchange.

Since grey markets are unregulated, there are higher counterparty risks. Investors do not get ownership rights of the company before the official listing and shares purchased on the grey market are not added to the demat account. Settlement typically happens a few days before the IPO listing when brokers register the shares in the investor's demat account after buying them in the public issue.

Types of Grey Market Trading

Trading in an IPO grey market involves two types of trading:

• Trading (selling or buying) allocated IPO shares before they list on stock exchanges
• Trading (selling or buying) IPO applications at certain rate (premium)

Trading IPO Shares

Lot of times, grey markets allow people to trade in IPO shares before they are listed in the stock exchanges. This is done at a premium called grey market premium (GMP). This market is also known as the over-the-counter market.

GMP is the additional amount over the IPO price that investors are willing to pay to buy the shares.

If the premium is high, more investors are likely to get involved with the IPO whereas a low or a negative premium indicates low interest and consequently fewer investors. In fact, grey market premium helps underwriters to gauge the IPO price.

GMP are also attached with words ‘buyer' and ‘seller'. They tell the price either at which buyers are willing to buy shares or the price at which sellers are willing to sell their IPO shares.

Certain examples will help in understanding the concept better:

Positive grey market premium: Suppose the issue price of Company XYZ is Rs 350. Grey market premium of XYZ is Rs 80 (buyers). In the given situation, the premium is positive. Because of positive premium, the buyers are ready to purchase the shares of XYZ at Rs 350 + Rs 80 = Rs 430.

Negative grey market premium: Suppose, in this situation the grey market premium of XYZ is Rs -30 (sellers). The issue price is Rs 350. Since the grey market premium here is negative, it means that the sellers are ready to sell the shares at a discount of Rs 30. Hence, they are ready to sell the shares at INR 320.

These premiums are not constant and they keep changing according to the changing demands. These fluctuations continue till the stock is listed on the exchange for trading.

In spite of the grey market premium being an indicator for the trend, many investors/traders feel it should not be taken too seriously. The reasons are as follows:

• The grey market is too small. The sample size is effectively insignificant and might not dictate the true demand.
• The grey market is unofficial and the transactions are not backed by regulations. Hence, manipulations are possible.
• There are other major factors such a fundamentals and economic trends that might dominate the direction of the stock. IPOs are often used for profit booking on the listing day. Due to heavy selling, stocks might even go below the issue price. If an investor invests just looking at the grey market premium, this might be a deal breaker.

Trading IPO Applications

Traders can also trade IPO applications on the grey market. This typically happens after the application window is closed but before the allotment takes place.

It is very rare for someone to trade IPO application post-allocation, as it would be better to trade IPO shares by that point.

As the allocation algorithm treats each retail application equally, buying IPO applications on the grey market acts as a way to increase the chances of share allotment.

It is important to remember here that this trade is not backed by SEBI and the buyer is trusting the seller to honour their word.

At the time of allotment, the seller will transfer all the shares allocated to them to the buyer, regardless of what the listing price may turn out to be later.

In return, they accepts Kostak over the issue price on the spot. Again, nothing is issued by the grey market to indicate this sale.

What Is KOSTAK?

Kostak (or price of application) is the premium amount at which IPO applications are being traded for in the grey market.

In other words, Kostak rate is a profit one makes by selling their IPO application even before allotment or listing of the issue.

It is especially useful for people who do not want to take a risk with IPO allotment or listing gains.

In simple terms, if you have a demat account but you don't want to subscribe an IPO, you can sell your application to an interested buyer in the grey market. Under these circumstances, your application will be subscribed by the buyer on your behalf and they will pay you a certain amount for that. The profit you make is kostak rate.

Kostak rates vary depending on the IPO. The advantage is that the buyer may gain or lose her money, but you will get a fixed kostak rate.

What Is Subject to Sauda?

Sauda refers to the speculative trading activity that happens in the unofficial grey market for IPOs in India. When a company is about to go public, its shares sometimes start trading in the grey market where brokers facilitate transactions between interested buyers and existing shareholders.

The pricing and demand discovered in sauda or the grey market is non-binding and considered speculative since it does not involve any formal issuance of shares by the company. The trading prices often see high volatility as various investors try to buy or sell shares in anticipation of the listing gains.

Small retail investors are more likely to fall prey to overpricing and manipulation in sauda. While it helps generate hype for the IPO, sauda remains an unregulated activity and lacks transparency. The only official price discovery happens once the public issue opens and the company allots shares to investors through a regulated process following the IPO price band and allocation norms.

What Factors Affect IPO GMP in the Stock Market?

The overall market sentiment at the time of the IPO plays a major role in determining the grey market premium (GMP) for an initial public offering (IPO). When broader markets are bullish, IPOs tend to have higher GMP as investor appetite and risk appetite increases. Bearish markets, on the other hand, see lower GMP for IPOs as investors become more risk-averse. The fundamentals of the company like the financial health, growth prospects, competitiveness etc., also drive interest in the IPO and impact the GMP. Companies with strong fundamentals and healthy financials can sustain a higher GMP as investors remain confident about future growth.

The demand and subscription levels during the IPO matter a great deal in determining the GMP. Higher oversubscription from qualified institutional buyers (QIBs) and retail investors leads to better price discovery and results in a higher GMP. Low demand, on the other hand, dampens the GMP.

The perceived valuations, listing gains expected, promoter reputation, and hype also influence GMP as optimistic investors are willing to pay a premium to buy pre-IPO shares in anticipation of strong returns on listing.

Can You Use Grey Market Information When Applying for an IPO?

Using grey market information when applying for an IPO is not recommended. The grey market is an unofficial and unregulated system where shares change hands between brokers and investors prior to the IPO. The pricing and demand indicators from such trades should be taken with caution as they can be manipulated. Grey market premiums tend to be highly volatile as speculative trading causes inflated prices far from the fundamentals. Basing your IPO application on such unreliable signals is risky. Moreover, regulators discourage using grey market data to make investment decisions regarding IPOs. The only valid price discovery happens once the company publishes the price band and allotment happens through the stock exchanges after the issue opens.

Relying solely on grey market movements can result in making ill-informed decisions under the influence of hype or manipulation. Fundamentals, financials, valuation and long-term prospects should guide your IPO application, not just grey market trends. While grey markets can help gauge initial enthusiasm, the unofficial nature makes it an unsafe metric when applying for shares in an IPO through proper channels. You should depend on your own research and analysis.

A Quick Recap

A grey market IPO is useful for several parties: companies issuing an IPO, their underwriters, start-ups, formerly big companies and most importantly, traders.

Although an unauthorized market, traders vouch for it because they can buy shares that haven’t been listed on the exchanges and there are possibilities of the share price swelling in future.