Uncovering Fraudulent Practices in Illiquid Stocks Trading

6 mins read

The nature of the stock market is complex and susceptible to malpractices. As an investor, you must be aware of such malpractices and not fall prey to the scams of fraudsters. In this article, we will let you know how bilkers trade in illiquid stocks to create artificial volumes and evade taxes.

Before looking into the fraudulent activities in illiquid stocks let us understand what are illiquid scrips.

What are illiquid stocks?

Illiquid stocks are stocks that fall into the high-risk category as they cannot be easily and readily sold or exchanged for cash. Usually, these are small stocks that cannot be realized quickly due to

  • Lack of cost
  • Low trading activity
  • High bid-ask spreads
  • No market depth and so on

As illiquid stocks cannot be sold immediately, they are negligibly traded.

How are stocks grouped under illiquid stocks?

Stock Exchanges places the securities that meet the following criteria under illiquid securities as per SEBI guidelines

A security that trades in the normal market and is not shifted to trade for trade settlement shall be classified as illiquid on a stock exchange if:

  • Average daily turnover of less than Rs.2 lakhs calculated for previous two quarters AND
  • The Security is classified as illiquid at all Exchanges where it is traded

Find out the list of illiquid securities on NSE and BSE.

Fraudulent practices in illiquid stock trading

Illiquid stock trade segments have been manipulated in the past to create artificial volumes, evade taxes, etc. by the method of reversal trading which involves buying and selling of stocks from and to the same counterparty during a day which creates an artificial volume of stocks.

  • Illiquid stock options trading and tax evasion

‘Operation Falcon’ was the investigation launched by the Income Tax department in which it unearthed Rs 8200 crore tax evasion in illiquid options trading on BSE, one of the biggest scams in the securities market. Let us look into the modus operandi of the scam i.e, reversal trading

In the first leg of the reversal trade, the entities would sell options without any corresponding off-setting position in the underlying scrip. The options were sold at an unreasonably low price, even below the intrinsic value at times.

In the second leg, the same option will be bought back by the same entity on subsequent trading days at a substantially higher price than the sale price.

The number of options bought and sold by the loss-making entities of a contract was identical. However, there was a significant difference in the sale value and buy value of the trades, resulting in significant losses to the company and profits to the options writers.

How does this help to evade taxes?

For example, if ‘X’ wants a manufactured loss of Rs 100 to reduce taxable income and Y wants to launder Rs 100 untaxed money, a broker puts X and Y on the opposite side of a series of trades in some illiquid stock options contracts. The trades will be matched such that Y makes a profit of Rs 100 and X gets a loss of the same amount. Later, money settlement takes place between X and Y covertly to settle amounts, by cash or other methods.

  • Illiquid stock trading and market manipulation

SEBI imposed fines of several lakh to crores on individuals and entities for carrying out fraudulent trades in the illiquid stocks. SEBI, in 2018, took action in a phased manner against 14,720 entities for “non-genuine trades” through illiquid scrips. The recent one is where SEBI imposed a fine of Rs 1.1 crore on 22 entities including individuals, for indulging in non-genuine trades in illiquid stock options of BSE on 31-Dec-2021(source: Economic Times)

In most of the cases, on the investigation, SEBI found out that the entities executed non-genuine synchronised trades by reversing trades with the same entities on the same day with wide variations in price (without any basis for such wide variation) which resulted in the generation of artificial volumes creating a misleading appearance of trading in the illiquid stock options contracts.

Measures to curb fraudulent practices in illiquid stocks trading

We found out how synchronized reversal trading in illiquid stocks is used to carry-out fraudulent trades to create artificial volumes and manipulate the market. To curb such malpractices:

Market Regulator SEBI looks into the fraudulent practices in illiquid stocks trading under Prevention of Fraudulent and Unfair Trade Practices relating to Securities Markets Regulations, 2003 and takes various measures accordingly as per the provisions of the regulation.

SEBIsuo-moto looks into the suspicious trades when it observes a deviation in the trades of illiquid stocks which are normally thinly traded in the market and conducts an inquiry and imposes penalties if the suspicion is found true.

Stock Exchanges(BSE and NSE) have taken the following measures to prevent malpractices in illiquid scrips:

  • Advises trading members to exercise additional due diligence while trading in these securities either on their account or on behalf of their clients.
  • On suspicion, Exchanges conduct an inquiry and impose a penalty on certain trades and collect penalties from the trading members if the maximum buy price entered by a client (on PAN basis) is equal to or higher than the minimum sell price entered by that client and if the resulting trades take place. The penalty will be calculated and charged by the Exchange and collected from trading members daily. Trading members may recover such penalties from clients.
  • Cautions investors through circulars and press releases to trade cautiously in the listed illiquid scrips often

Angel One has taken the following measures to safeguard the interests of investors,

  • Doesn’t allow margin and intraday trading in illiquid stocks to prevent the malpractices in illiquid stock trading and if they are bought in delivery products, they can be sold only after the settlement is done in case of the equity segment.
  • Restricts/Blocks certain Future and Options contracts on its trading platforms to avoid malpractices or erroneous trading if they meet any of the following criteria:
  • Open interest value in the contract is less than 25 lakh

For Futures contract, Open interest x Closing prices < 25 lakh,

For Options contract, open interest quantity x (strike price + closing Premium price) < 25 lakh OR

  • In the case of Option contracts, if strike price falls (+,-) 30 % of the previous day closing price of that particular scrip in cash market OR
  • All contracts having expiry more than 6 months

(Note: If you wish to trade in the contracts that fall under the above categories, you can connect with Angel One Customer Care)

SEBI and other market intermediaries keep a vigilant eye on the everyday trading activities in the securities market to prevent the misuse of the securities market.

As an investor, you must be aware when you see a spike in the volume or price of an illiquid stock to avoid becoming a victim of manipulative and deceptive trading practices. We suggest you make informed choices before making any of the investment decisions.