Why did Zerodha send an email seeking clarification for the reversal trades?

SEBI and stock exchanges mandate the stockbrokers to monitor and report trading activity that is not performed in the normal course of transactions, also referred to as Abnormal or Non-genuine transactions. One such type of trade which has to be reported by stockbrokers is a reversal trade.

Reversal trades are transactions that effectively cancel each other out in terms of market position but may create artificial market activity or result in tax advantages, loss transfer, or other financial benefits outside normal market operations.

Reversal trades occur when the same client or related clients buy and sell identical contracts within a short time period at significantly different price points. Key characteristics include:

• Same client or related clients on both sides of the transaction
• Short time interval between buy and sell orders
• Significant price differences between transactions
• Consistent profit pattern for one party with losses for another
• Often occurring in illiquid contracts with limited market participation

SEBI requires brokers to take specific actions regarding suspicious trading patterns:

• Identify potentially non-genuine transactions
• Seek explanations from the clients involved
• Document and report explanations to regulatory authorities
• Take precautionary measures when necessary

As per regulations, when abnormal trading patterns are detected, Zerodha has the authority to freeze the amount equivalent to the value of the trades or the resulting profit/loss. The decision to withhold client funds, along with a detailed explanation of the reasons, must be communicated to the stock exchange within 1 day of freezing funds. The final determination on whether transactions are considered abnormal or non-genuine rests solely with the Exchange, whose verdict is conclusive and binding on all parties involved.

The Exchange makes the final determination on whether trades are abnormal or non-genuine, and their decision is binding. The inquiry is part of mandatory due diligence, and clients should provide prompt explanations for their trading strategy.