Trading on the inside

The speed with which the Securities and Exchange Board of India issued an order prohibiting an offshore hedge fund — Factorial Master Fund, which was found guilty of insider trading — from dealing in Indian securities is commendable. It was in the second week of March this year that the hedge fund had short sold future contracts of L&T Finance Holding, a day prior to the offer for sale of the company, and then bought them again through the OFS. The hedge fund appears to have had prior knowledge that the OFS would be priced at ₹70, much below the ruling market price. That SEBI completed the investigation and passed an order against the guilty in less than three months is a reflection on the availability of software to sift through the colossal amount of trading data generated everyday and zero in on abnormal trades. Passing an injunction against a large institutional player sends the signal to investors that the regulator is keeping a tight vigil on market’s operations.

It is common knowledge that leaks originate from merchant bankers handling primary and secondary offers — usually the work of a rogue employee. In this case, the organisation handling the offer of sale held discussions with over 70 institutional investors in order to arrive at the offer price. And Factorial was one of the investors involved in these discussions. SEBI’s order does mention that further investigations are needed to establish how the offer price was leaked to the hedge fund. But the regulator should use this episode to put in place rules on the procedures that brokers, consultants, investment bankers and others in possession of unpublished, price sensitive information need to adopt to ensure its protection. Conversations with clients involving such information need to be documented and there should be a clear set of rules for employees in possession of such news. It may be recalled that the front-running case in 2010 involving a dealer in HDFC mutual fund had led to most mutual funds banning cell-phones within dealing rooms, setting up surveillance cameras and other rules for equity dealers. Similarly, this case can be used by SEBI to sensitise financial institutions on the need for implementing processes to prevent insider trading.

Another significant aspect of the case is the manner in which Factorial was able to take 84 per cent of the open position in the future contract of L&T Finance. The SEBI order has said that this order disrupted the equilibrium between the spot and future price in the stock. As the ongoing rally attracts more hedge funds which trade through participatory notes, SEBI needs to think about bringing in some curbs to protect our market from such disruptive external influences.

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