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What is the IPO Grey Market?6 min read

February 4, 2021 4 min read

What is the IPO Grey Market?6 min read

Reading Time: 4 minutes

An IPO grey market is an unofficial market where IPO shares or applications are bought and sold before they become available for trading on the stock market.

When companies wish to raise funds to fuel their growth, they sell a part of their stock on the stock market. This process is called an initial public offering, or IPO. However, before they become officially available on the stock market, they trade, unofficially, in the IPO grey market, which is also termed a parallel market or an over-the-counter market.

Since it’s unofficial, inevitably, there are no regulations that govern it. The Securities and Exchange Board of India (SEBI), stock exchanges, and brokers have no part to play in it. These transactions are undertaken in cash on a one-on-one basis.

Interestingly, this marketplace is also used for trading stocks that might not be associated with an IPO. For instance, start-ups—i.e., companies that have just begun their operations to develop a unique product in the market and are initially funded by the entrepreneurial founders—and spin-off companies—i.e., companies, which for better administration, are created as a new subsidiary of their parent company—also may be traded in the grey market as they test the waters before they spend time and money to be listed on a major stock exchange. Apart from that, delisted companies, i.e., companies that earlier traded on a major exchange but later suffered financial trouble or failed to meet SEBI’s terms to be eligible for trading on the stock market, may also be traded in the grey market.

Let’s look at some important terms associated with the IPO grey market.

What is Grey Market Premium and Kostak Rate?

The Grey Market Premium (GMP) refers to the premium that investors are willing to pay over the issue price—the price at which IPO shares are offered for sale before they are officially listed on the stock market.

For instance, let’s assume that the stock price for a pharma company, Pharm-Me, is ₹100. If the GMP is ₹150, it implies that investors are ready to buy Pharm-Me’s shares for ₹250 (i.e., ₹100+₹150).

For that matter, the GMP could give an indication about how the IPO might trade on its listing day.

The Kostak Rate, meanwhile, relates to an IPO application. So, the rate at which an investor buys an IPO application before the listing is termed the Kostak rate.

For instance, Shyam wishes to invest in the pharma company, Pharm-Me. However, he does not have his own Demat account. He approaches Ram, who has a Demat account and is capable of applying for the IPO. Shyam will pay Ram ₹1000 per application. This is the Kostak rate. Since there are five applications, Shyam will pay Ram ₹5000. This means that Ram has secured a profit of ₹5000. Now, even if Shyam gets allotted just two applications, Ram’s profit of ₹5000 remains as is.

How does Grey Market work?

There are two ways in which the IPO grey market works. You can either trade IPO shares in the grey market or you can trade IPO applications in the grey market.

Let’s understand both of these with examples.

First off, let’s look at how shares are traded on the IPO grey market. Kabir, a real estate agent, has applied for pharma company Pharm-Me’s shares via the IPO. He could be a seller in the IPO grey market. Pharm-Me is offering per share at ₹100 (which is the issue price) and a total of 20 shares per application.

Arjun, a stock market enthusiast, is of the opinion that Pharm-Me’s shares value is more than its issue price of ₹100. He begins collecting Pharm-Me’s shares before they are allocated through the IPO process. He is a buyer in the IPO grey market.

Arjun approaches Imran who is a dealer in the IPO grey market. He places the order to buy Pharm-Me’s share at a GMP of ₹50, i.e., he is ready to pay ₹150 per share.

Kabir is a novice. He isn’t very sure about Pharm-Me’s prospects after it gets listed. He is not ready to take that risk. So, he contacts Imran, notifying him that he wishes to sell Pharm-Me’s shares. Imran offers to buy the shares at a GMP of ₹50. Kabir likes the GMP offered by Imran and finalizes the deal to sell Pharm-Me’s 20 shares at ₹150 per share.

On the day of allotment, Kabir gets allocated an application, i.e., 20 shares. Imran asks Kabir to transfer the same to Arjun’s Demat account, while Arjun pays Kabir ₹3000 (₹150 * 20 shares) through Imran.

In case if no shares are allocated to Kabir, no shares are exchanged, and the deal dies a natural death.

Now, let’s look at how IPO applications are traded in the IPO grey market.

Similar to when shares are traded in the IPO grey market, even the trading of IPO applications includes buyers and sellers.
The buyer, stock market enthusiast Arjun, decides the price of Pharm-Me’s application based on thorough research and careful analysis.

Through dealer Imran, he lets Kabir, the novice investor, and real estate agent, know that he is ready to buy the entire IPO application at ₹1000. Kabir prefers not to take a risk and ends up selling Pharm-Me’s application for ₹1000.

Here, Kabir does not have to worry about the allotment of shares in the IPO. Whether or not shares are allocated, he gets his ₹1000 profit that he made when he sold his application to Arjun.

Why do investors trade in the Grey Market?

First, because it’s an excellent opportunity for investors to purchase a company’s shares even before they are listed, especially if they feel that the company’s stock will increase in value. Second, if an investor wishes to exit the IPO before it is listed, the IPO grey market is an avenue. Third, if an investor has missed the deadline for the IPO application or wishes to buy more shares then they can approach the IPO grey market.

What is in it for the companies?

For companies, the grey market is a great way to know how the demand for their shares is and how the company’s share might perform once it is listed.

Conclusion

The IPO grey market is an unofficial market that performs outside SEBI’s purview. Thus, there are no guarantees. All transactions are undertaken on the basis of trust and carry counterparty risk. Apart from that, an IPO grey market could be used to gauge how the company’s stock will perform once it is listed.