Circular Trading - Explained
What is Circular Trading?
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Table of ContentsWhat is Circular Trading?How Does Circular Trading Work?Example of Circular TradingHow does Circular Trading Manipulate the Market?What Consequences are there in Circular Trading?
What is Circular Trading?
Circular trading refers to a fraudulent trade scheme. The process involves a broker entering orders, while fully aware of the number of shares, price, and the time the orders will be entered. In other words, the process is usually intentional for the purpose of boosting the shares price in the market. Note that circular trading eliminates competition. Also, it does not benefit shares change ownership, but there is an increase in trade volume. These two reasons make it illegal as the procedure goes against the existing regulations.
How Does Circular Trading Work?
To achieve circular trading, there must be a conspiracy between numbers of parties for the outcome to be a fraud. Note that circular trading and wash trading are different, however, they have the same outcome. What makes them different is that wash trading is executed by one investor while circular trading by a group. Basically, circular trading is of the idea that trading volume directly impacts the price of the share. When there is trading volume, share value is expected to rise to make them be overvalued. Investors usually take advantage of this to buy shares so that they can maximize the returns. Generally, when investors get a signal to buy shares, it creates interest where it is not necessary. This makes circular trading a fraudulent activity. This practice has been banned in most countries as it is considered unethical. However, circular trading does have a huge financial impact on the accounts of the companies. Through circular trading, companies are able to achieve the following:
- Inflating the turnover
- Acquire big loans from banks or financial institutions
- Availing GST credits on transactions
Note that all these activities increase money.
Example of Circular Trading
Lets assume that we have Company A, which deals with steel supply. This company sells steel to company B. Then company B sells the same steel to company C. To complete the cycle, Company A buys back the same steel from Company C. In the above example, goods are never relocated from one firm to the other in real sense. What happens is that there is an illegal transaction taking place where invoices are fabricated. These invoices are then produced between the three firms involved in the collision. Note that where an actual transaction is involved, this transaction pattern does not exist as it is unethical.
How does Circular Trading Manipulate the Market?
If circular trade becomes persistent, then it may create false stock activity, hence influencing stocks price in the market. Lets assume that security's price in the market was headed to fall to a certain level as desired by some investors. If this is the case, then a circular trade would be used to strengthen the share price. This will bring an impression to the market that stocks in the market are trading at a desirable price level. This may influence others who are not part of the scheme to purchase the stock with the assumption that there is stock interest growth. Also, the presumption that the firm is made known in public, will lead to the price rising up. In case the shares price doesn't rise, then the value will be deceitfully inflated. The moment the scheme comes in the open, the prices will collapse with the entire amount others had invested.
What Consequences are there in Circular Trading?
It is worth noting that circular trading is considered a serious offense without bail for offenders. Also, the police have the authority to arrest those found guilty even without an arrest warrant. They are also allowed to initiate an investigation without seeking a court order.