Insider trading—the act of trading a company's stock or other securities by individuals with access to non-public, material information about the company—has long been the white-collar crime equivalent of a magic trick: often suspected, rarely proven.
A US court case involving a former Goldman Sachs (NYSE:GS) banker and his squash partner has catapulted the issue back into the headlines as well as underlining the need to combat the issue once and for all.
Now, a pioneering research study by Vinay Patel of the University of Technology, Sydney, and Tālis Putniņš of the Stockholm School of Economics in Riga suggests that the secret machinations of this old art form may soon be unmasked.
Patel and Putniņš have developed a novel model capable of detecting potential insider trading activities, presenting new methods that promise to boost surveillance, deterrence, and enforcement efforts.
Their findings offer a shocking insight into the prevalence of the malpractice: insider trading occurs far more frequently than the number of prosecutions by regulatory authorities would suggest.
In fact, they estimate the actual rate of insider trading is at least four times higher than the number of legal actions brought by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ).
Utilising an ingenious approach dubbed the detection-controlled estimation (DCE) model, Patel and Putniņš sift through trading data preceding major company announcements and flag those with a high or low likelihood of insider trading.
By studying the estimated probability of insider trading based on the DCE model, they have generated startling insights into the underbelly of Wall Street.
Spotlight on the ‘insider’
Insider trading is a dark corner of finance often illuminated only by high-profile scandals. Martha Stewart’s conviction remains in the public consciousness nearly two decades on, while the example cited in the intro provides insights into the mechanics of the practice. In essence, it involves trading a public company's stocks or other securities based on material, non-public information about the company.
Insiders—those in possession of such privileged information—could range from company executives to employees or external parties such as lawyers, analysts or consultants. When these insiders use their privileged information to gain an unfair advantage in the market, they violate both legal and ethical boundaries.
Under the current US and UK legal systems, insider trading is a criminal offence. Yet, the act of proving it and the subsequent prosecution has always been a complex and nuanced process. The difficulty lies in distinguishing trades made on the back of legal knowledge and analytical prowess from those driven by illegal insider information.
The authors of the research, Patel and Putniņš, stress that insider trading is far more prevalent than the number of prosecutions suggest. By their estimates, about one in five mergers and acquisitions (M&A) events and one in 20 quarterly earnings announcements are subject to insider trading—a staggering revelation that brings the extent of this illicit practice into sharp focus.
Abnormal returns
Patel and Putniņš's research examines abnormal returns and volumes before the announcement of major company news. Their findings indicate that insider trading is more likely to occur when there is more liquidity in the market, which allows insiders to blend into the trading crowd and potentially earn higher profits without drawing attention.
Interestingly, the research also suggests that insider trading tends to increase when the value of inside information is greater. This is measured by the market reaction to the news announcement. For instance, the study finds that insider trading is more likely ahead of M&A events, which often result in significant market movements.
Furthermore, the research reveals that smaller target firms, where the value of inside information is larger, show higher pre-announcement returns and dollar volumes traded. This seems to suggest that insider trading is more likely to occur in these firms.
Conversely, for earnings announcements, the opportunities for profitable insider trades are more likely to occur in larger firms. These are typically the firms that have the capacity to generate earnings surprises and hence, are more frequently covered by analysts.
Modus operandi
Drawing from the research conducted by Patel and Putniņš, it becomes apparent that some methods of insider trading are seemingly more effective than others.
Among the most effective methods, according to the research, is the use of complex financial derivatives. These financial instruments allow insiders to leverage their positions in a more discreet manner and potentially reap significant gains from small initial investments. The complexity of these instruments can often obscure the detection of insider trading activity, thus offering an apparent advantage to those engaging in such illicit activities.
Using Exchange Traded Funds (ETFs) is another effective method employed by insiders. ETFs offer exposure to entire sectors or indices rather than individual stocks, thereby dispersing the financial impact across various assets. This can make it challenging for regulators to pinpoint any suspicious transaction.
However, Patel and Putniņš's research also points out that while these methods may seem effective at first glance, they're not without their risks. They involve complex financial instruments that can lead to substantial losses if not properly understood or managed.
In terms of less effective methods, the research suggests that direct stock trading, particularly in liquid markets where a sudden large volume of trade can be noticeable, is becoming increasingly risky. Thanks to advancements in technology and regulatory surveillance capabilities, regulators are becoming more adept at detecting and prosecuting this more traditional form of insider trading.
Further, Patel and Putniņš's research underscores the effectiveness of whistleblowing programs in deterring insider trading. These programs incentivize individuals to report suspicious activities, creating a higher risk of exposure for those engaging in illicit trades.
In essence, while some methods might offer more discretion and potential profitability than others, none are infallible or exempt from the watchful eye of regulators. The chance of detection and the ensuing severe penalties should act as powerful deterrents against insider trading, regardless of the method employed.
Regulation and its efficacy
One would assume that the scale of insider trading Patel and Putniņš have uncovered might imply a failing in the system. However, their study has shed light on certain regulatory mechanisms that seem to be effective in deterring insider trading.
The SEC Whistleblower Program, which encourages people to report possible securities law violations, appears to have been notably effective in curbing illicit insider activities. Patel and Putniņš found that the conditional detection rate has increased over time, partly due to this program and partly due to increases in the SEC budget.
However, this is not to suggest that the current regulatory regime is adequate. The researchers believe their findings on the determinants of insider trading and its detection could be instrumental for regulators in their pursuit of more effective surveillance and enforcement strategies.
Implications for investors
Patel and Putniņš’s revelations bear significant implications for investors too. Insider trading, being an illicit practice, disturbs the fair and equitable functioning of financial markets. It creates information asymmetry where a certain group of traders are privy to material non-public information, thereby gaining an unfair advantage. This undermines investor confidence and deters genuine participants from actively engaging in the market.
The sophisticated private investor may wonder: If insider trading is so pervasive, how does it impact my strategy? It's a pertinent question. Volatility can spike around corporate announcements, thanks to insiders loading up on shares or offloading them ahead of the news. Understanding the prevalence of insider trading might lead some investors to reconsider the risk-reward ratio of trading around these times, and perhaps even encourage them to adopt a more cautious strategy.
Investors may also want to give a second thought to their selection criteria for investments. Smaller firms, for example, may be more susceptible to insider trading given the more substantial relative impact of insider information. This research may prompt a reassessment of the risk premiums demanded for such investments.