Are you usually captivated by the ever-changing numbers in your stock portfolio? It’s a common fascination, but there’s more to the financial markets than meets the eye. In this article, we are about to reveal the top ten dark secrets of financial markets often kept from the view of everyday retail investors.
The Context
Many retail investors hold the belief that the guardians of financial markets maintain fairness, creating a level playing field for all investors to place their bets.
In many aspects, this belief holds true. In India, among many specified agencies, the Securities and Exchange Board (SEBI) functions as regulatory police for financial markets, striving to bring structure and order to the money madness. However, considering the magnitude and variables involved, it’s inevitable that negative elements persist.
Let’s face it, we’re discussing money, often regarded as one of the most potent sources of corruption. Beneath the surface, amid the hustle and bustle, lies a hidden world deeply entangled within the chaos. This covert realm seeks to exploit the very rules of the financial game.
In this article, we encourage you to temporarily shift your attention away from your typical financial interests and get into a more mature exploration of the ten hidden and dark secrets of the financial markets.
1. High-Frequency Trading (HFT) Algorithms
High-frequency trading (HFT) algorithms function as turbocharged racing engines on steroids within the financial markets, conducting trades at a velocity that surpasses the capabilities of both humans and standard computers.
These algorithms give a select few traders an unfair advantage, granting them the ability to purchase or offload assets in mere milliseconds ahead of the competition. The result? A windfall of profits for this fortunate elite, while everyday investors find themselves lagging far behind, struggling to keep up with the pace.
Due to the hefty expenses associated with computing power and high-speed internet connections, it’s primary institutions that have been recognized for capitalizing on this advantage. Some of these entities go to the extent of establishing their offices close to stock exchanges, ensuring they capture data packets before they traverse any further. Algorithmic trading is entirely within the bounds of the law in India, regardless of whether you’re a retail investor with the means to engage in it or an institutional player.
We’ll leave it to your contemplation from here.
2. Insider Trading
One of the most concerning issues in the financial world is insider trading, which can cast doubts on the integrity of the market. It’s a practice that can be challenging to detect and prove in a court of law due to its intricate nature. Essentially, insider trading involves trading securities using confidential information not accessible to the general public.
For instance, in 1996, Hindustan Lever Ltd. (HLL) acquired 8 lakh shares of Brook Bond Lipton India Ltd. (BBLIL) just two weeks before announcing their merger. This raised suspicions of insider trading, leading SEBI to investigate HLL.
HLL was part of Unilever, the parent company of BBLIL. SEBI believed that HLL and its directors had prior knowledge of the merger’s potential impact on stock prices, categorizing them as insiders.
The Securities Appellate Tribunal (SAT) supported SEBI’s findings, prompting adjustments to the definition of “unpublished” information. Speculative media reports were no longer considered as published information, and a new category called “price-sensitive information” was introduced, encompassing merger details.
This distinction between those with access to inside information and the general public can have significant implications, potentially disrupting the fair and level playing field that retail investors rely on for equitable treatment.
3. Dark Pools
Dark pools, often shrouded in secrecy, are trading platforms reserved for large institutions or groups, enabling them to conduct substantial transactions away from the public’s view. Although they intend to reduce the impact on the broader market, concerns arise regarding transparency and fairness due to their limited regulatory oversight.
An analogous Indian concept is “Dabba Trading,” which finds common use in commodity trading. These practices are marked by a lack of organization and a heightened level of risk.
It’s worth noting that dark pools have not gained extensive traction in India as of yet. Nonetheless, the Indian securities market has been progressively moving towards increased automation and efficiency in recent years, raising the possibility that dark pools may gain prominence in the market in the future.
4. Market Manipulation
Manipulative techniques like spoofing and pump-and-dump schemes have the potential to disrupt stock prices and erode investor confidence. A recent example from June 2023 underscores this issue: The Securities and Exchange Board of India (SEBI) issued an interim order along with show-cause notices, restraining 135 entities from participating in the securities market. They were accused of manipulating the shares of five small-cap companies: Mauria Udyog Ltd, 7NR Retail Ltd, Darjeeling Ropeway Company Ltd, GBL Industries Ltd, and Vishal Fabrics Ltd.
These entities orchestrated a scheme to artificially inflate stock prices by sending bulk SMS messages with “buy” recommendations to the public. Price volume influencers were identified as key actors who boosted both the price and trading volume of these five stocks through manipulative trades, followed by the dissemination of buy recommendations.
This recent incident serves as a stark reminder of how swiftly and dramatically markets can be manipulated, often leaving smaller investors to bear the brunt of the consequences.
5. Front-Running
Front-running occurs when a broker or fund manager first places personal orders to capitalize on expected price changes and then carries out orders for clients. This unethical practice corrodes trust in financial intermediaries and violates the core principle of fiduciary duty. Mutual fund offices and major brokerage institutions typically uphold strict confidentiality rules. However, the involvement of people does not eliminate the risk of misconduct.
In a notable incident dating back to May 2022, Axis Mutual Fund, one of India’s largest mutual fund houses, took action by suspending two of its fund managers due to grave allegations. These allegations were directed at two individuals who were implicated in front-running activities. They were accused of accepting payments from brokers in exchange for divulging confidential information and conspiring with them to execute unauthorized orders. One of these individuals held the position of chief trader and equity fund manager, while the other was an assistant equity fund manager.
The Securities and Exchange Board of India (SEBI) responded by taking action. They issued an Interim Order cum Show Cause Notice to these two individuals involved in the Axis Mutual Fund front-running case, along with 20 others who played a role in exposing their methods. SEBI determined that Rs 30.55 crore had been illicitly gained through these front-running activities and directed the confiscation of this amount. Interestingly, within the fraudulent ring, the primary accused was referred to as ‘Jadoogar’ (the magician) in their WhatsApp messages.
6. Pump and Dump Schemes
Pump and dump schemes involve artificially inflating the price of a stock through misleading statements, only to sell it off at a profit, leaving unsuspecting investors with worthless shares. These schemes prey on gullibility and wreak havoc on portfolios.
In March 2013, SEBI uncovered a pump-and-dump-style manipulation involving two micro-cap companies, Sadhna Broadcast and Sharpline Broadcast, in two separate interim orders. The scheme aimed to lure small retail investors into purchasing these stocks by publically sharing false information.
This misinformation included claims of an imminent acquisition by the Adani Group and significant contracts with Sony Pictures and Zee Media. Sebi took action following complaints of price manipulation and share offloading in the Sadhna stock. The complainants asserted that misleading YouTube videos propagated false and deceptive news, encouraging investors to buy Sadhna stock for supposed extraordinary profits.
7. Shadow Banking
“Shadow banking” is like a parallel banking world that mimics traditional banking activities, like lending money. However, it operates outside the regular banking system.
One significant risk with shadow banking is something called “maturity transformation.” This means they use short-term money to invest in long-term assets. It’s a bit like borrowing money for a short time but using it for something that takes a long time, which can cause problems if they can’t repay the short-term loans on time. This can lead to issues with having enough money when they need it.
Shadow banks work on their own, separate from traditional banks and their rules. While this independence allows them to be flexible and innovative in finance, it also comes with substantial risks that could harm the overall financial system’s stability.
In India, a common example of shadow banking is Non-Banking Financial Companies (NBFCs). They act like banks but are monitored by the Reserve Bank of India to make sure they follow the rules and don’t do anything wrong. However, it’s essential to remember that not all shadow banks are closely watched by regulators. This lack of oversight can be problematic because it means they might not follow the rules, potentially causing issues in the financial world. That’s why it’s crucial to keep a close eye on them and regulate them effectively.
8. Complex Derivatives
Financial derivatives can be incredibly intricate. When used responsibly, they serve to manage risks, but their misuse can have devastating consequences. A prime example of this is the mortgage instrument that played a pivotal role in the 2008 financial crisis, known as the “mortgage-backed security” (MBS). These were exceedingly complex and questionable financial products created by bundling thousands of individual home mortgages into a single security that could be bought and sold by investors.
The issue arose when many of these underlying mortgages were “subprime,” meaning they were offered to borrowers with poor credit histories. As housing prices began to decline, a significant number of these subprime borrowers defaulted on their mortgages, causing the value of the MBS to plummet. Consequently, financial institutions and investors worldwide who held these MBS suffered substantial losses.
The widespread ownership of these intricate and interconnected MBS products, combined with the inability to accurately assess the associated risks, multiplied the severity of the 2008 financial crisis. This crisis triggered a chain reaction that resulted in the collapse of major financial institutions, a severe credit crunch, and a global economic downturn.
9. Rating Agency Biases
Credit rating agencies (CRAs), including well-known names like Moody’s, Standard & Poor’s, and Fitch, hold a vital role in evaluating the creditworthiness of financial products and economies. However, conflicts of interest can sometimes lead to ratings that are biased, potentially causing confusion for investors and worsening instability in the market.
In a recent research paper authored by David F. Tennant and Marlon R. Tracey titled “Are Poorer Countries Disadvantaged by the CRAs?“, among various findings, it was suggested that S&P, Moody’s, and Fitch encounter greater difficulty in upgrading the credit ratings of poorer countries compared to wealthier ones, even when these countries show improved ability and willingness to repay their debts.
10. Regulatory Capture
Regulatory capture happens when industries manage to exert influence or control over the very regulatory agencies designed to supervise them. This compromises the regulatory process, as seen in cases where financial institutions managed to avoid significant consequences for their actions.
A notable instance illustrating this issue can be found in the nuclear power industry. It serves as a classic example of “regulatory capture,” where the industry gains a level of control over the agency responsible for regulating it.
Conclusion
These ten dark secrets of financial markets serve as a stark reminder that the world of finance is far from transparent or equitable for retailers. While regulations and oversight aim to curb these practices, vigilance and investor education are essential tools in navigating this complex landscape. As investors, it’s crucial to be aware of these secrets and advocate for a fair and transparent financial world, where everyone has a chance to prosper.
Knowledge and information are your greatest allies when it comes to protecting your investments and participating in financial markets. Stay informed, stay vigilant, and remember that the best defense against these dark secrets is an educated and empowered investor community.
Happy Investing!
