What is a grey market?
A grey market exists outside of official exchanges for financial securities. It’s an unregulated, speculative market where traders can buy or sell stocks not officially listed through an IPO, or which have been delisted or suspended.
A grey market allows the issuer and underwriters to gain a sense of future demand prior to listing on an official exchange. It gives investors an opportunity to get in on the ground floor. While a grey market is unregulated, it is not illegal and serves a useful function for all parties.
Grey market explained
In order to properly define the grey market and explain its meaning it’s useful to look at the etymology. The black market is a widely known term used to describe any market which operates illegally and away from public scrutiny. Black markets include narcotics smuggling and illegal weapons trading. There are financial black markets, such as illegal currency trading with a sanctioned government.
On the other side is the white market, a regulated stock exchange with publicly listed stocks, or other financial instruments. In white market trading, pertinent information is openly available to the general public. A listed company will publish regular financial statements to aid investment decisions.
The grey market falls between the two.
Example of a grey market transaction
Grey market stock transactions are always conducted over-the-counter (OTC) through brokers or other trading providers because the underlying stock is unavailable on the exchanges. A good example is a company likely to announce an IPO.
Traders who believe the stock is likely to be overvalued or undervalued at the IPO can purchase it beforehand – transactions are settled at the close of the first day of trading. If the closing price is higher than the price paid prior to the IPO, the trader’s made a profit. If the post-IPO price is lower, the trader’s made a loss.
Why trade on the grey market
Grey market trading is not for everyone. Due to it being unregulated and the higher potential for parties to back out of deals, some institutional investors, such as pension funds, do not trade on the grey market.
Less risk-averse traders looking for potential above-market returns use the grey market to capitalise on opportunities. Although rewards can be attractive, there is little recourse if they get it wrong and the market performs unfavourably.