Stock exchanges take great care to ensure that their 'price discovery mechanism' another word for economist Adam Smith's Invisible Hand, remains untampered with. To do this, they need to ensure that all buy orders placed online match with the best possible sell orders in terms of price and quantity. This ensures that the resulting price, volume and volatility of a security is the best possible representation of the market participant's mood. The National Stock Exchange, for example, operates on an automated order-driven trading system called National Exchange for Automated Trading (NEAT).

This system offers the online market participants anonymity along with control on the type of orders placed by them. Every order gets a timestamp and an order number. Despite automation & anonymity in the order processing algorithms of the exchanges, the buy and sell orders placed by the same participant can sometimes match. This results in what is called a Synchronised Trade. Although this trade is a wash (not resulting in a change of ownership), it is still recorded as a legitimate trade by the system.

What is Synchronised Trading?

Securities Appellate Tribunal (SAT) in Securities and Exchange Board of India (SEBI) vs. Pursarth Trading Company Pvt. Ltd. [1] defined it as:
Synchronised trade is a kind of transaction where the seller and buyer execute the trade for almost the same quantity and price at the same time. It is important to note that in such a trade, sellers never lose ownership or control over the security that they trade in.

Most of the times such trades are involuntary. But at times, by matching the buy and sell orders, a trader or a group of traders, can trade amongst themselves in high volumes and can intentionally manipulate various indicators of a security like its price, volume, etc.

Forms of Synchronised trading

Self Trades
When a trade is executed by an entity, in such a way that the entity is both the buyer and the seller in that particular trade, it is called a Self-trade [2]

Reversal Trades
In this strategy, two people execute the trades in such a way that the purchaser of the security eventually sells the security back to the original seller, and as a result, beneficial interest is not changed.

Circular Trading
SAT in M/s. Active Finstock Pvt. Ltd. v. SEBI [3] explained circular trading as:
A circular trade is a trade where two or more persons join hands together and start trading in a script among themselves Irrespective of the number of persons trading, and the number of trades executed by them, the shares go back into the hands of the first person at the end.

Cross Deals
Cross deals take place when a buyer and a seller have a common trading member (Broker) who executes their trade orders. If the orders punched by the trading member are such that they have similar price and quantity, and are executed around the same time then they can match.

When Synchronised Trades are unintentional.
The orders placed by traders could get synchronised without any premeditation or any mala fide intention on their part. This could be due to the complexity of the modern markets, the exchange's inefficiency in executing orders or the prevalence of software-based trading. After looking at some of the conditions discussed below, it becomes clear to say that synchronised trades in some capacity are bound to occur as any prudent trader or a trading firm can fall within the conditions mentioned below.

Algo-Trading
Algorithm Trading uses software algorithms that evaluate price and other empirical data, to decide when to place buy and sell orders in order to make a profit. They are frequently used for arbitrage and inter-day trading, and the software often places multiple orders in a short span of time to take advantage of the price difference. Needless to say, not all orders find a match, and sometimes buy and sell orders from the same algorithm match each other and get executed by the exchange. Alternatively, when multiple algorithms are deployed in the market by the same trading firm, these algorithms may end up executing each other's orders. This happens automatically and with no malevolence on the part of the firm.

Technological Limitations
All Exchanges have limitations in the speed of their servers or the amount of traffic their network can handle and market participants can have limitations in the bandwidth at which they operate. An exchange may have its servers situated in one physical location, but the trading terminals which transmit orders to it may be located the world over. These reasons could cause a 'latency' or a time delay in transiting the order to the exchange in the first place. This affects the exchanges ability to match orders and could result in orders piling up or mismatching of the orders. All this coupled with the high-frequency trading activity could result in trade synchronisations.

Manual Trading
Multiple people in a single firm may trade manually on behalf of the firm with their independent trading strategies. There are chances that their orders may get synchronised if they deal in similar securities. This is especially true for a Proprietary trading firm.

Effects of Synchronised Trading

On the Market
When synchronised trades are executed in high numbers, they start to change the basic indicators of a script. The perpetrators can increase or decrease in the price of a script, as they place high volume sell orders with the price of their choosing, and then execute the orders themselves. On the other hand, due to the high number of trades entered, the volume of the script increases, and this shows an increase in the demand for the shares. The main outcome of this activity is that the perpetrators creates a false market for the script where its buying and selling activity is taking place at higher than normal prices, and in higher than normal quantities. SAT has held that it is this effect of misleading the decisions of genuine investors and tampering with the natural process of price discovery that makes synchronised trading a fraudulent trade practice [4].

On the Investors
Investors in the security markets use certain information or indicators to invest in a script. These modern-day indicators can be very complex; but they are calculated using very basic information about a script like its price, volume, earnings, etc. For potential investors to make the right decisions, it is imperative that this basic information is a true representation of the market's sentiment; or in other words, the price discovery mechanism of the market is not contaminated. If it is, then it could expose the investors to an unmitigated risk on their investments.

On the Brokers
When perpetrators don't wish to manipulate a securities price/volume by using synchronised trades, they use it to reward their brokers for illegal activities performed by them. In the 2012 London Interbank Offered Rate (LIBOR) Scandal [5], banks manipulated the lending rates with the help of their brokers. Later, they had to find a way to pay the brokers for their role in this scam. Some of the banks engaged in self-trading activity, which generated higher than normal commission fees payable to their brokers. The commission from these self trades inflated the broker's bills, and they were compensated legally for their unlawful role in this scam.

Brokers could place buy and sell orders on their behalf of multiple clients using their own terminal. Some of these orders placed may unintentionally get synchronised and executed. SEBI in Re. Khandwala Securities Limited [6] has clarified that due to its KYC Norms for the brokers and the Member-Client Agreements between the broker and their clients, a broker is duty-bound to know the investment objective and genuineness of its clients. Also, that brokers have a duty not only towards their clients but also towards the market in protecting its order matching mechanism. Thus, brokers can be held liable for synchronised trades executed by them and it's irrelevant if such a trade deal is negotiated in advance between the buyer, seller and broker or not.

How are trades established as Synchronised Trades?

Various tests and attendant circumstances are looked at to determine the existence of synchronised trading activity as given below:
Price, Quantity And Time (PQT) Test
In this test, the price, quantity and time of placing the buy and sell orders are looked at to establish if the trades are synchronised. A positive PQT Test, along with the existence of the other circumstances mentioned below, is a strong indicator of synchronised trading activity.

Connections between Clients and Brokers
In Rajkumar Chainrai Basantani v. SEBI [7], SAT held that Circular Trading is established if commonality of clients and their nexus with the promoters is proved. When a commonality exists between two market participants they are called 'Connected Clients' and as far as SEBI is concerned the connection may be of having a common director, of being an associate company of the other, of being related parties of each other or merely of being each other's friends on Facebook. This commonality may exist inter se the clients, the brokers or various other market participants. SAT emphasises that unknown persons cannot trade continuously by executing buy and sell orders that synchronise between them. As a result, it can infer that if trades are synchronised between the parties continuously, one could say that the parties are related and the transactions are not bona fide.

Change In Beneficial Ownership
SEBI's Master Circular [8] defines a beneficial owner as the natural person or persons who ultimately own, control or influence a client including those who enforce ultimate control over a legal person. It could also be the person on whose behalf a trade is executed. After a garden variety trade is executed on a stock exchange, the buyer in the trade is not controlled or influenced by the seller in any manner. As a result, the buyer becomes the true owner of the securities. However, In a synchronised trading activity the first person never loses its control and influence on the shares and on the entities that buy and sell it subsequently. Thus, no transfer of beneficial interest takes place.

Incremental Trades
Incremental trades are those where there is a steady increase in the price element of the orders executed between the connected parties, that results in inflation of the price of the security. If the trades are predetermined and the volume of shares traded is high enough, incremental trading can drive the price of the script above the ordinary price determined by the free price discovery mechanism of the market. In SEBI v. Galaxy Broking Ltd. [9], it was observed that incremental trades were executed by connected parties (with an increment of Rs. 2 each day with reference to previous days closing price) across 11 trading days. This drove the price of the script from Rs. 70.70 to Rs 107.85, thus registered an increase of 52.55%.

Capacity to trade in volume
To get the fruits of an illegal synchronisation, the participants have to be in a position to trade a high number of shares in order to see a difference in the price of the security in the market. This is a position of influence that not all the players will have in the market. Minor and infrequent trades that pass the PQT Test, even if executed by Connected Parties, cannot drive the price or volume in any direction.

In SEBI vs Active Finstock Pvt. Ltd. [10] attendant circumstances play a key role. Here, SEBI investigated the script of M/s Mazda Fabrics & Processors Ltd for synchronised trading activity. The entities under SEBI's lens were the broker Active Finstock Pvt. Ltd., promoters of the company M/s Mazda Fabrics and managers to the issue of the said company. SEBI was able to establish an interrelationship between these 3 entities and it looked at their commonality and their nexus with the promoters of MFPL and held that these were reason strong enough to hold that trading activity between them was synchronised and was done with a view to inflate the price/volume of the script of M/s Mazda Fabrics.

In SEBI vs Galaxy Broking Ltd. [11], SAT held that a broker's knowledge of a synchronised trade could be inferred not only from the PQT test of the trades but also, by the fact that such trades took place several times, continuously, for several days.

Does Synchronised Trading violate the law?

SAT in SEBI v. Kishore R. Ajmera (2016) [12] mentioned that 'Synchronised Trading per se is not prohibited, and is regulated by SEBI regulations in India'. In certain cases, the effects of Synchronised trading in creating a disequilibrium in the market can be severe. Therefore, the parties are held liable for their actions under Sec. 15-HA of SEBI Act, 1992; Regulation 3 & 4 of SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2005; and Schedule II clause A of Brokers Regulations, 1992.

SAT in Ketan Parekh v. SEBI (2006) [13] took the position that:
A synchronised transaction even on the trading screen between genuine parties who intend to transfer beneficial interest in the trading stock and who undertake the transaction only for that purpose and not for rigging the market is not illegal and cannot violate the regulations. As already observed, 'synchronisation' or a negotiated deal ipso facto is not illegal. [...] Whether a transaction has been executed with the intention to manipulate the market or defeat its mechanism will depend upon the intention of the parties which could be inferred from the attending circumstances because direct evidence in such cases may not be available.

Supreme Court in SEBI v. Rakhi Trading (2018) [14], held that even if premeditated synchronised trades don't manipulate the market directly, they are by themselves undesirable transactions in securities as they go against the principles of fair play and transparency used in securities trading. It also pointed out that crucial factors affecting the market integrity, which may be direct or indirect, can lead to violation of the PFUTP Regulations.

Measures of controlling such trades: India and elsewhere

Synchronised trades are at best a nuisance, and at worst manipulative. As a result, many stock exchanges and regulators have put in place various barriers to prevent self trades from taking place at a basic level.

In India, BSE enhanced its existing Self Trade Prevention (STP) mechanism in October 2015, by putting in place a PAN based order matching filter which tries to stop such trades on a fundamental level. Some exchanges like NYSE, Euronext, NASDAQ, have also implemented STP mechanisms that trigger an alert when self trades occur.

In The UK, Financial Conduct Authority's guidance FCA MAR.1.6.2 [15] defines Wash trades and emphasises the need for change in beneficial ownership of the security traded to be established as a Wash trade.

In 2013, The US SEC tabled Financial Industry Regulatory Authority's (FINRA) proposed rule change governing self trades up for public comments [16]. The proposed amendment stated that any self trade executed by the trading activity of two unrelated algorithms or two distinct trading strategies from the same firm would be generally considered as bona fide transactions. It also issued guidelines for members to review their trading activity and have policies in place to deter self trades originating from their trading desks. It went on to say that isolated self trades that originated from the same trading desk/algorithm or related trading desks/algorithms would also be bona fide, provided that the firm's policies and procedures were well designed.

End Notes:

1. https://indiankanoon.org/doc/1163095/
2. Pg 5-6, Joint Staff Report on The U.S. Treasury Market on October 15, 2014, Published July 13 2015
3. https://www.sebi.gov.in/enforcement/orders/nov-2010/in-the-matter-of-m-s-active-finstock-pvt-ltd_13821.html
4. SAT in SEBI v. Galaxy Broking Ltd. on 11th Jan 2008
5. https://www.sfo.gov.uk/cases/libor-landing/
6. https://www.sebi.gov.in/sebi_data/attachdocs/1451534604416.pdf
7. https://indiankanoon.org/doc/1724109/
8. https://www.sebi.gov.in/legal/master-circulars/dec-2010/aml-cft-master-circular_14421.html
9. https://indiankanoon.org/doc/1274717/
10. https://indiankanoon.org/doc/1192248/
11. https://indiankanoon.org/doc/1274717/
12. SEBI%20v.%20Kishore%20R.%20Ajmera%202016
13. https://www.sebi.gov.in/satorders/ketanorder.pdf
14. https://indiankanoon.org/doc/63300860/
15. https://www.handbook.fca.org.uk/handbook/MAR/1/6.html?date=2016-03-07
16. https://www.sec.gov/rules/sro/finra/2014/34-72067.pdf