Insider trading

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Insider trading
Informal practice commonly found in worldwide
World map.png
Map of worldwide, where Insider trading commonly takes place.
Entry written by Ilja Viktorov.
Ilja Viktorov is affiliated to Department of Economic History, Stockholm University.

Original text: Ilja Viktorov, Department of Economic History, Stockholm University

'Insider trading' in financial markets refers to trading in securities such as equity and bonds by market participants who have access to exclusive information about the issuer of a particular security before such information is released to the general public. This allows insiders to benefit from buying or selling shares before they fluctuate in price.

The longest prison sentence for insider-trading in the United States—11 years—was handed down in 2011 to hedge-fund manager and billionaire Raj Rajaratnam. Following this case, in 2012 the American judiciary found Rajaratnam’s business partner Rajat K. Gupta (former Goldman Sachs director and CEO of global consultancy firm McKinsey & Company) guilty of leaking non-public corporate information to Rajaratnam. Gupta was sentenced to two years in prison for conspiracy and securities fraud. Access to insider information had enabled Rajaratnam to make profits on trading stocks (and to avoid losses) to the tune of US$64 million, part of these gains resulting from Gupta’s tips (Raghavan 2013)[1].

Insider trading has been present throughout the history of financial markets, and was particularly prevalent during periods of speculative stock market bubbles. Because of the strong influence of US anti-insider trading laws on other jurisdictions, the English word ‘insider’ is used in most languages.

In most European Union (EU) member-states, a legal distinction is made between primary and secondary insiders. Primary insiders gain access to information by virtue of their position, employment or responsibility. They include controlling shareholders, corporate executives and officers, as well as financial-market professionals who compile information on a firm’s operation. Government officials with access to insider information also fall into this category. Secondary insiders are friends or relatives of primary insiders, acting on tips and referred to as ‘tippees’ in the American legal tradition (Alexander 2007)[2].

Insider trading is closely associated with price-manipulation in financial markets, such as the creation of special corporate events to influence price movements of specific securities with the aim of eventual profit-making (Engelen and Leiderkerke 2010)[3]. While the practices associated with insider trading are less aggressive and more widespread than price-manipulation, they are considered dubious and unethical. Since trading in securities may be viewed as a zero-sum game between market participants, insiders’ profits mean losses for their counterparties, including small and institutional investors such as pension funds. Empirical studies from the US and UK found that insiders earned abnormal profits above the average market-price fluctuations (Seyhun 2000; Friederich et al. 2002)[4][5].

The US was the first country to ban insider trading. Since the nineteenth century, the American stock market had been the world’s largest, with broad popular involvement in securities-trading, including the investment of pension savings in equities. The Great Crash of the American stock market of 1929 provoked the development of a complex regulative framework against insider trading. Initially, this was based on legislation such as the Securities Act of 1933 and the Securities Exchange Act of 1934, and on rules imposed by the powerful Securities and Exchange Commission (SEC) which investigates insider dealings. However, in accordance with common law tradition, the subsequent evolution of the anti-insider legal framework came to depend more on judicial interpretations in particular cases and court decisions. Thus, the actual prohibition of insider trading in the US was delayed until the 1960s, and lacked codification in the form of a specific anti-insider law. This makes the American judicial anti-insider trading framework somewhat contradictory and inconsistent. At the same time, the lack of a specific legal code provides more flexibility for the implementation of legislation (Bewaji 2012; Bainbridge 2013)[6][7].

To meet the requirements of the SEC, US investment banks separated flows of information between their own departments by instituting ‘Chinese walls’. These information barriers are purely normative, though in some cases departments dealing with mergers and acquisitions or research are physically separated from the trading department. The purpose of a ‘Chinese wall’ is to restrict access to information by employees who are not directly involved in delivering services for the bank’s corporate customers. Otherwise, non-public information may leak beyond interdepartmental ‘walls’ and other bank employees may potentially use it for insider trading in securities (Bartos 2008: 187-188)[8].

Under the pressure of financial globalisation, the American experience of anti-insider legislation has spread to the rest of the world. Most advanced economies with developed financial markets have made insider trading illegal: France in 1970, the UK in 1980, Japan in 1988, Italy and Denmark in 1991, Austria in 1993, Spain and Germany in 1994. In the EU, the implementation of anti-insider laws was driven mainly by the European Community Insider Dealing Directive of 1989. Criminalisation notwithstanding, legal definitions of insider trading vary substantially between jurisdictions (Alexander 2007: 37-81; Engelen and Leiderkerke 2010)[9][10]. There is no universal take on the type of securities or other financial instruments. For example, UK insider-trading legislation exempts shares of public sector bodies while their debt securities are affected. In the US, courts have been reluctant to apply anti-insider laws to debt securities (Bewaji 2012)[11]. In Japan, non-listed securities and treasury instruments are excluded from anti-insider legislation. Actual enforcement of insider-trading regulation also varies (Bhattacharya and Daouk 2002)[12]. So far, the US remains the jurisdiction with the strongest record for enforcement. It has seen a significant number of legal cases where long prison sentences have been imposed on insiders found guilty of illegal trading, while enforcement tends to embrace a broader range of insiders (Bainbridge 2013)[13].

Insider trading is common in developing countries, where it is practised by a wide range of market participants, corporate officers and regulative authorities. Quantitative studies of this practice in the emerging markets are virtually absent because of a lack of reliable data and actual non-enforcement of anti-insider legislation. Interviewing market participants remains the main research method, making qualitative approaches of economic sociology and oral history an integral part of the few available studies in the field.

Despite evolving anti-insider legislation, there is a significant discrepancy between legislation and its implementation. The case of anti-insider trading regulation in China is illustrative. China’s insider trading legislation began to develop in the 1990s but its implementation was delayed until the late 2000s, the drawbacks including state regulators’ lack of independence and accountability, selectiveness of legal enforcement, and low levels of judicial expertise to hear difficult cases (Huang 2013)[14].

Wunmi Bewaji’s (2012)[15] empirical study of insider trading in Nigeria attests to the broad abuse of insider trading in domestic financial markets. The release of corporate news does not generally lead to a change in share prices, since potential profits have already been taken by insiders before any such information is made public. More importantly, the Nigerian practice of insider trading highlights the unrooted nature of anti-corruption legislation when forcefully imposed on emerging markets. Few financial market professionals have an adequate understanding of insider trading or are aware of the existence of Nigeria’s anti-insider legislation.

In post-Soviet Russia, insider trading and market manipulation appeared with the emergence of the securities market in the 1990s. Foreign—mainly American—consultants played an active role in the formation of financial market institutions, leading on several occasions to conflicts of interests (Wedel 2001)[16]. Ironically, Russia’s only to date case of insider trading and market manipulation was uncovered by the American judiciary as part of the ‘Harvard Affair’ (McClintick 2006)[17]. High-ranking Russian officials were also engaged in speculation in the government short-term bond GKO market (Viktorov 2015)[18]. Since the 2000s, insider trading has been practised mainly by Russian state bureaucrats and corporate executives, who are well aware that their conduct is unethical. Such dealings are kept secret, though market participants usually know whose interests a particular stockbroker represents. Because of strong resistance by influential government ministers and oligarchs, the ban on insider trading was delayed until 2010, when a special anti-insider law was finally adopted, but its actual enforcement remains a task for the future.

Insider trading is internationally recognised as a serious problem by both financial market regulators and legislators. The evidence shows, however, that closing the gap between the introduction of a formal legislative framework and its implementation takes time. There is no uniform legal interpretation of insider trading. In particular, attempts to transplant the American model, grounded in the common law legal tradition, to countries with a civil law tradition makes implementation of legislation even more difficult.

Notes

  1. Raghavan, A. 2013. The Billionaire's Apprentice: The Rise of The Indian-American Elite and The Fall of The Galleon Hedge Fund. New York: Business Plus
  2. Alexander, R.C.H. 2007. Insider Dealing and Money Laundering in the EU: Law and Regulation. Aldershot: Ashgate
  3. Engelen, P.-J. and Leiderkerke, L. van. 2010. ’Insider trading’, in J. R. Boatright (ed.), Finance Ethics: Critical Issues in Theory and Practice. Hoboken, NJ: Wiley: 199-221
  4. Seyhun, H. N. 2000. Investment Intelligence from Insider Trading. Cambridge, MA: MIT Press
  5. Friederich, S. et al. 2002. ‘Short-Run Returns around the Trades of Corporate Insiders on the London Stock Exchange’, European Financial Management, 8(1): 7-30
  6. Bewaji, W. 2012. Insider Trading in Developing Jurisdictions: Achieving an Effective Regulatory Regime. New York: Routledge
  7. Bainbridge, S.M. 2013. ‘An overview of insider-trading law and policy: An introduction,’ in S.M. Bainbridge (ed.), Research Handbook on Insider Trading. Cheltenham: Edward Elgar: 1-32
  8. Bartos, J. 2008. United States Securities Law: A Practical Guide, 3rd edn. London: Kluwer Law International
  9. Alexander, R.C.H. 2007. Insider Dealing and Money Laundering in the EU: Law and Regulation. Aldershot: Ashgate
  10. Engelen, P.-J. and Leiderkerke, L. van. 2010. ’Insider trading’, in J. R. Boatright (ed.), Finance Ethics: Critical Issues in Theory and Practice. Hoboken, NJ: Wiley: 199-221
  11. Bewaji, W. 2012. Insider Trading in Developing Jurisdictions: Achieving an Effective Regulatory Regime. New York: Routledge
  12. Bhattacharya, U. and Daouk, H. 2002. ‘The World Price of Insider Trading’, Journal of Finance, 57: 75-108
  13. Bainbridge, S.M. 2013. ‘An overview of insider-trading law and policy: An introduction,’ in S.M. Bainbridge (ed.), Research Handbook on Insider Trading. Cheltenham: Edward Elgar: 1-32
  14. Huang, H. 2013. ‘The Regulation of Insider Trading in China: Law and enforcement’ in S. M. Bainbridge (ed.) Research Handbook on Insider Trading. Cheltenham: Edward Elgar: 303-326
  15. Bewaji, W. 2012. Insider Trading in Developing Jurisdictions: Achieving an Effective Regulatory Regime. New York: Routledge
  16. Wedel, J. 2001. Collision and Collusion: The Strange Case of Western Aid to Eastern Europe, 1989-1998, 2nd edn. New York: Palgrave Macmillan
  17. McClintick, D. 2006. ‘How Harvard Lost Russia’, Institutional Investor, 40(1): 62-90.
  18. Viktorov, I. 2015. ’The State, Informal Networks and Financial Market Regulation in Post-Soviet Russia, 1990-2008’, Soviet and Post-Soviet Review, 42(1): 5-38