Dark pool platforms under focus post-Sebi’s Ketan Parekh order

Earlier this month Sebi issued an order against Ketan Parekh and related entities for alleged front running

The Securities and Exchange Board of India (SEBI) investigation into front-running allegations against Ketan Parekh and Rohit Salgaocar has thrown a spotlight on the use of unregistered “dark pool” platforms by foreign portfolio investors (FPIs) in India. These platforms, such as Liquidnet and ITG Posit (now owned by Virtu Financial), facilitate order matching for large equity trades, effectively acting as intermediaries between FPI buyers and sellers, said people with direct knowledge of the matter.

Large FPIs like mutual funds and insurance companies usually deal in large chunks of equity stakes. When these funds want to buy or sell large stakes in a company, they use the dark pool platforms to find a counterparty among other FPIs since all large funds subscribe to such services. Once a counterparty is found, these platforms forward the order to the Indian broker, who executes the order on stock exchanges. The dark pool platforms receive something akin to a finder’s fee from both the seller and buyer.

Emails sent to Sebi and Liquidnet seeking comments remained unanswered. ITG Posit was acquired by Nasdaq-listed Virtu Financial. An email sent to Virtu Financial remained unanswered.

Grey Area in the Sebi rules

To be sure, it is not illegal for FPIs to use such platforms. However, these platforms do not fall under the purview of any Sebi regulations, say legal experts. “Generally, unregulated platforms are not allowed to deal with stock market-related activities. The dark pool platforms also undertake order matching, which only registered stock exchanges are allowed to do in India,” a person cited above said.

Any news regarding large buy or sell orders being placed by an institutional investor is treated akin to unpublished price-sensitive information(UPSI), and people using such information to make personal gains have been penalized by Sebi in the past. The person cited above also said brokers are required under Sebi rules to accept orders only placed by the client. “In this case, brokers are accepting orders through a third party and not the client. There is also a chance of information leak and front running like in the Ketan Parekh case,” said the person cited above.

In the Ketan Parekh case, Rohit Salgaocar acted as a middleman for several FPIs, and he used the information to front-run trades via Parekh.

FPIs can place orders directly through direct market access(DMA) provided by exchanges, or they can do the same through local brokers. Most foreign funds prefer going through local brokers since they don’t have any physical presence in India.

On stock exchanges, FPIs can buy or sell large quantities of shares through two routes: block deals and bulk deals. A block deal is an exclusive window open for 15 minutes before market opening where buyer and seller are privately matched. FPIs often don’t prefer this window due to pricing restrictions. Under block trade, shares can be sold at a price not more than/less than 1 percent of the previous close. “While buying or selling large shares, FPIs often negotiate price, which is not consistent with a 1 percent restriction. Also, block deals cannot be made during mid-market hours,” said a second person cited above.

On the other hand, a bulk deal is a transaction where more than 0.5 percent of a company’s capital is being traded. There is no price restriction in this route, and if a large trade is done during market hours, it is captured as a bulk deal. It is like a regular trade order; the only peculiar aspect about a bulk deal is exchanges disclose details of all bulk deals and several big trades by FPIs are captured as bulk deals.

“In bulk deals, a fund would not put in a single large order since it will have a high impact cost. Instead, they place multiple smaller orders simultaneously through various brokers. This opens them up to risk of information leaks and potential front running since several brokers and their trading desks would be aware of the order,”  the second person cited above added.

In order to avoid such leaks, FPIs route their orders through these platforms, where they first find a counterparty and then place the order on the exchange platform. In the past, FPIs have raised concerns over data leaks in bulk deals. They had asked Sebi to lift the pricing restrictions on the Block deal route so that their trades could be privately matched.