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The Mystery of Cycle Trading: How Does This Stock Market Scam Really Work?
Circular trading is a type of securities fraud that can occur in the stock market that can lead to price manipulation and is often associated with a "pump and dump" scheme. Circular trading occurs when several traders place identical buy and sell orders at the same time, in the same quantity and price. Such transactions do not actually change the ownership of the shares, but they create the illusion of increased trading volume.
The basic concept behind cyclical trading is that an increase in trading volume is widely considered to be a signal that a company is about to experience an important event, such as a new product launch or management change. Therefore, investors will buy the stock as a result, expecting the subsequent increase in the share price. However, such signals have no real basis, and investors' buying behavior is purely based on false market enthusiasm.
Not only are these practices illegal, they are also widely considered immoral and are therefore banned in many countries.
Market consequences
In a common form of circular trading, groups of investors falsely drive up a company's share price and then sell their shares at a profit. Although it is illegal, the consequences in the market are often minimal. In some cases, circular trading can even directly affect the success or failure of a company.
When shareholders set specific share price thresholds to decide whether to continue investing or increase their holdings, circular traders may manipulate the share price to keep it within the price range that is most favorable to them. Such manipulation could have serious implications for the overall market, especially during the initial public offering (IPO) phase.
The excitement of fraudulent manipulation can cause companies to be significantly overvalued, ultimately causing investors to suffer heavy losses and undermining market confidence.
Famous Cases
Circular trading is most prevalent in India and has been the subject of many high-profile cases, notably the 1999 Ketan Parekh case. He was convicted of circular trading and insider trading involving seven companies that worked together to manipulate the market, illegally boost stock prices, and then unloaded their shares shortly after the IPO.
In another case, in 2001, the Securities and Exchange Board of India (SEBI) found that Angell Broking had attempted to manipulate the share price of Sane Information Ltd by creating fake trading volumes over a period of about a month. This cyclical trading behavior caused the company's stock price to soar in a short period of time and then fall rapidly.
Those involved in circular trading often turn a blind eye after discovering market anomalies, causing the entire market's confidence in stock prices to be greatly reduced.
Countermeasures
Since 2010, SEBI has taken various measures to prevent circular trading. This includes establishing price bands, where a particular stock can only be traded within a certain price range on a given day. SEBI has set a 10% price band for all stocks in the market since 2018.
In addition, trading margin was introduced, requiring brokers to deposit a small amount of funds as transaction fees when placing each transaction order, which fundamentally reduced the number of unnecessary orders placed by brokers.
While circular trading is still possible, the associated fees make it less easy.
Challenges Ahead
Although existing market supervision mechanisms are continuously improving, timely identification of circular traders remains a challenge. Some studies conducted in academia, such as the analysis by Palshikar et al., have begun to explore methods to identify collusion among traders. Using a network-based approach to analyze the correlations among traders will help to more accurately monitor and combat cyclical trading behavior in the future.
As the market evolves, how close are we to identifying these illicit activities?
