Circular trading is a fraud scheme that involves the manipulation of price, often related to pump-and-dump schemes. Circular trading is when identical buy and sell orders are entered with the same price and number of shares.
The brokerage firm enters sell orders knowing that there has been or will be a corresponding group of buy orders at the same time, amount of shares, and price. Consequently, there’s no positive change in the ownership of the shares, but it appears that the trade volume has increased. Circular trading results in a false sentiment about stock activities, which can impact the price.
It is, however, different from wash trading, in which identical results are accomplished by the activities of a single investor rather than a group of investors. This type of trading can be practiced via a group of people working together to obtain fraudulent results.
The Mechanism of Circular Trading
The idea of circular trading is taking advantage of the fact that trading volume directly affects the price of shares. Increases in trading volume usually indicate that something significant is occurring in firms. As a result, investors tend to purchase shares to profit from the predicted growth in their value. Consequently, the share’s value increases and usually gets overvalued by investors.
The Impact of Circular Trading on the Market
While circular trading is unlawful, the ramifications on market conditions are minor in most cases. It is utilized less commonly to affect the success or failure of a company in a direct way.
But suppose you are a day trader. In that case, you might encounter such scams and succumb to them when you notice the high volume activity of certain stocks and purchase them, expecting the stocks’ values to rise.
Shareholders may be involved in various circumstances. They establish price thresholds at which they’ll determine whether to stay involved in a firm or exit it, as well as the ones at which they’ll determine whether to buy another share. As a result, losing an insignificant number of prominent shareholders could jeopardize the company’s conditions.
In the case of Initial Public Offerings (IPOs), circular trading might seriously affect the market. The hype and buzz surrounding IPOs are critical determinants of their success. Attempts to unlawfully manipulate that amount of excitement could result in a significant overvaluation of a company. Consequently, a company that seems to have a lot of potential gets more hyped than it should, and it finds itself with expectations and demands that it just can't meet, an initial investor then loses money when this happens, and the stock market’s confidence as a whole is eroded.
Aside from the large market implications, the implications for private investors are equally substantial. They may invest in a stock for more cash than it's worth.
Mechanisms to Overcome Circular Trading
Since the advent of incidents in India in 2010, strategies for combating circular trading have been in development. The Securities and Exchange Board of India (SEBI) has started to use a variety of tactics to combat this illegal schema. This is accomplished by tightening stock market regulations to prevent high-volume stock trading in short time periods. A price band, for example, is a price range that is specified for a day, and a certain stock is only allowed to be traded during that day and within a specific range of price.
They may, however, limit meaningful price swings in corporations when a significant event occurs. SEBI considers changing the price ranges based on market conditions to overcome such problems.
