SEBI Watch: Proposed suspicious trading norms, a slippery path to take

June 15, 2023

SEBI Watch: Proposed suspicious trading norms, a slippery path to take

Last month, Securities and Exchange Board of India laid out in the public domain its intention to come out with a new regulatory framework on the prohibition of what it termed as “unexplained suspicious trading activities in the securities market.” The consultation paper it issued in this regard gave the entire draft of the proposed SEBI (Prohibition of Unexplained Suspicious Trading Activities in the Securities Market) Regulations, 2023, and SEBI’s rationale behind it.

These new norms are not needed. It can also potentially leads to an undesired ‘guilty till proven innocent’ outcome.

SEBI’s raison d'etre for bringing these is the challenge it is facing in gathering direct evidence due to the usage of sophisticated technology such as disappearing messages in social media or messaging platforms by entities who may be violating norms on front running, price manipulation, and insider trading.

SEBI said in the consultation paper that it had always followed the 'preponderance of probability' principle to hold persons liable for breach of norms in stock market trading such as 'pump and dump' schemes, front running and insider trading. But "the use of innovative, vanishing, and encrypted methods of private communication, as well as complex and untraceable funding arrangements, makes it impossible to establish the preponderance of probability," it said.

Innovations in technology will always lead to good use and bad use. The misuse of such technologies is a problem for all regulatory bodies worldwide, particularly when it pertains to serious acts of misconduct.

But the solution, as put forth by SEBI in the draft norms, is not to forcibly put forth a “deemed to be violating the securities laws” tag on select trades which the regulator finds suspicious. Besides other fundamental problems with such a presumption, market participants who make legitimate use of innovative technologies will also get caught in the vortex of regulatory suspicion.

As per the draft of SEBI’s proposed new norms suspicious trading activity is defined as "any trading activity of a person or a group of connected persons found to be exhibiting unusual trading pattern in a security or a group of securities where such unusual trading pattern coincides with material non-public information in relation to a security or a group of securities."

One problem with this definition is that the scope is very wide and entails a high degree of subjectivity.

To be sure, the new norms do say that the unusual trading pattern will mean a repeated pattern of trading activity which "involves a substantial change in risk taken in one or more securities over short period of time.. (and which) consequently delivered abnormal profits or averted abnormal losses during the period." But there is no objective quantification of what constitutes a “substantial change in risk”, “short period of time”, and “abnormal profits or averted abnormal losses.”

There is also a potential problem that the trading data chosen to be analysed by SEBI or the stock exchanges may end up being selective, since detailed objective criteria are not supplied. It runs the risk of the regulators picking the cases they wish to punish so long as they can show suspicion.

What makes matters worse is what follows next after the regulator concludes that the trading activity was suspicious. SEBI will open an official probe charging the entities and persons with indulging in presumed suspicious trading activity. Show cause notices will be issued. At present SEBI can officially summon market participants and intermediaries to get information before reaching a preliminary conclusion and issuing a show cause notice.

In the next step, under the proposed new norms, the concerned entities and persons charged with having engaged in the suspicious trading activity will have to rebut the same with not just an explanation but also with documentary evidence.

Now, in some cases, it simply won’t be possible for market participants to rebut by way of high standards such as “documentary evidence.” For instance, if a trader or an investor has traded on hearsay market rumours and not due to an elaborate manipulative scheme, how will he or she prove that is so with documents?

Going ahead, if SEBI contends that the charged persons and entities "failed to effectively rebut the allegations and thus have engaged in unexplained suspicious trading activity," it shall go the full way of taking enforcement action such as a freeze on their demat and bank accounts, penalties, a bar on securities market activities.

SEBI must re-evaluate the need for having separate regulations for suspicious trades. Existing regulations prohibiting insider trading, price manipulation, and front running activities, provide enough leverage to show a preponderance of probability. These also have safeguards in place to ensure that an undesired regulatory overreach does not take place.

If all regulators worldwide go about deeming dealings or activities of market participants they regulate as violative then the securities markets will end up becoming a regulatory wild west and push away genuine investors and traders.

 (link to published story on informistmedia.com --> https://www.informistmedia.com/chome/draft-regulation-suspicious-trading-slippery-path/