Gray list is the list of the stocks that are restricted for trading by the investment bank’s risk arbitrage division and this list includes those companies that are in contact with the investment banks for matters relating to merger and acquisition and these stocks can be traded again once they have completed with the business with these banks.
Gray List Definition
Gray list is the list of stocks wherein an arbitrage division of investment bank is restricted to take a position. This is primarily due to banking activities like M&A being carried out on such stocks by their Investment Banking M&A division.
Thus, the arbitrage division of that bank or any other financial institution will be prohibited from trading in that particular stock as the outcome is not certain. While the arbitrage segment cannot trade in ‘Gray Stocks’ but the other departments can trade on this ‘Gray Stocks’ and they are not barred from trading. The regulatory body keeps its eye on the different departments of the banks to stop any sort of malpractices which would eventually lead to unethical consequences. The arbitragers would likely be making handsome profits from the information leakage from the ‘Investment banking’ team.
Example of Gray List
If Stock X (Market capitalization of $100 million) is going to merge with Stock A (Market capitalization of $300 million) and the Investors of Stock X is suspecting of getting one share of Stock A against every 2 shares held. This is very lucrative for Stock X. As the market capitalization of Stock A is three times of Stock X and that’s why the ratio should be one share of Stock X against every share of stock X. Thus before the decision comes out Stock A will fall and Stock X will rise.
Again if the ‘Investment Banking’ division of ABC Bank is doing the merger and acquisition between Company A and X, then they would be the first one to get informed about the upcoming mergers. So the ‘Arbitrage’ Department would be barred from taking a position in Stock A and Stock X. As, the regulatory body is aware there might be a chance of leakage of information before the actual decision has been made.
Advantages of Gray Lists
- It omits the risk of when a trade is being made on particular derivatives of a stock that is going through merger and acquisition. The primary reason is to hold the NAV of investors and to restrict abnormal losses.
- The stock market reacts negatively when there is ambiguity. In case of any mergers and acquisitions, the volatility of the stock increases and can trade upward or downward depending on the Fundamental news. In case of positive news, the traders who have shorted the stocks in their respective derivative market would tend to lose as there is an amount of positivity for the company which would get reflected in the Stock price and in its derivatives. The opposite situation is also possible.
- Protecting the investor’s wealth is the prime purpose of the regulatory body. So, these stock which has a larger amount of risk would be barred from trading by the particular banks trading and arbitrage division.
Disadvantages of Gray Lists
- In spite of having ‘Chinese Wall’, there might be leakage of information from ‘Investment banking’ division to the ‘arbitrage’ segment. The leakage of information might lead to ‘unethical’ practice. So, an Internal Audit is required to avoid these practices.
- High Confidentiality and high security need to maintain when these separate operations are taken into considerations.
- Mergers and Acquisition happen in most of the corporate world and there is a certain amount of uncertainty that prevails along with it. So, it is not a good option to trade for the ‘traders’ and ‘Arbitragers’. In most of the cases, the regulatory body should bar the scrip for a while until the actual fundamental news comes in.
- A lot has to depend on the secrecy maintained by two separate departments of the banking or Financial institution.
- In case of any positive outcome from ‘mergers & acquisition’, investors won’t be able to participate in the Stock movement, as the ‘arbitrage’ desk will not allow participating in the stock’s movement.
- The traders and the ‘Arbitragers ‘of other institutions can quite continue trading in most of the time.
- Sometimes the team members of the ‘Investment Bankers’ might transfer the information to other organizations or institutions that might have an arbitrager department as well. These things are very hard to find out, as there is a sense of personal contact is involved in each case. Thus on the other hand, if the Regulatory body finds out any relation between the members of the other two institutions, the regulatory body might question both the party.
Important Points to Note about Change in Gray Lists
- Change in Gray Lists depends on the Investment Bankers who are conducting the ‘Mergers & Acquisitions’.
- Till the news of mergers and acquisitions arrives, the ‘Arbitrage’ section of the same Investment Bankers division should be barred from taking a position on the Derivative Segment of that particular stock.
- After the news has arrived, the volatility of the stock will reduce. Then the Gray list can be changed and the particular Arbitrage segment of that that Investment Banking group can be allowed for making arbitrage positions on that particular scrip.
- However, there is no such change for the ‘trading department’ of that particular group.
Data has become the ‘new oil’ for the modern business world and the same is applicable for the modern-day trader and the Arbitrager. They use to take advantage of short term volatility to make handsome profits. But if the fundamental reason for a particular stock is known before the announcement made by the management itself, it can term as ‘unethical’ for traders.
Thus to regulate any means of unethical practices the regulatory bodies have barred the ‘Arbitrager’ segment from doing any sort of manipulation or taking any advantage from the ‘Investment Banking’ department in advance. This kind of malpractices can be restricted through proper security and checklists like the introduction of the ‘Chinese wall’, properly maintenance of secrecy should be maintained between the two departments of the Bank.
This has been a guide to what is a Gray List and its definition. Here we discuss examples of gray list stocks along with advantages, disadvantages, and limitations. You can learn more about financing from the following articles –