Thursday, 1 March 2012

Gekko is back

Michael Douglas received an Oscar for his role as Gordon Gekko in the 1987 film Wall Street. He remains famous for his line “greed is good”. Aficionados should rejoice: Gekko is back but in a new role as spokesman of the Federal Bureau of Investigation in its war against insider trading. His new line: “If a deal look too good to be true, it probably is”.

Insider trading refers to trades of securities by individuals based on non-public information. Such transactions are considered as unfair since one side of the trade has private information that has not yet affected the price of the security. Therefore, lawmakers consider that insider trading is bad for financial markets. Regulations to ban trading on inside information have been introduced in the US as early as 1934. Other countries implemented similar rules, although more recently (see Bhattacharya and Daouk 1992). This theme keeps lawmakers busy on both side of the Atlantic. In Europe, for instance, the European Commission is currently working on MAD II, the second incarnation of its Market Abuse Directive.

Academics are not sure that insider trading is all bad. Leland (2002) summarized the arguments as follow:

Pro.-(a) Insider trading will bring new and useful information into asset prices. Decision makers-both portfolio managers and firms making real investment decisions-can reduce risk and improve performance when prices reflect better information. (b) Because of reduced risk, asset prices will be higher and more real investment will occur.
Con.-(a) Outside investor will invest less because the market is “unfair”. Asset prices will be lower and less real investment will occur. (b) Market liquidity will be reduced, thereby disadvantaging traders who must trade for life cycle or other reasons not related to information. (c) Insiders trading will make current stock prices more volatiles, further hurting traders with liquidity needs.”

Sorting through these arguments will take time and the outcome is uncertain. It should be based on empirical evidence. Measuring the benefits of insider trading requires calculating the difference between the “wrong price” and the “right price”. In a beautiful paper, Liza Meulbroeck (1992) analyses stock price effect of insider trading in the US. She finds that “the stock market detects the possibility of informed trading and impounds this information into the stock price.” Markets might be better than regulators to detect insider trading. More recent evidence is badly needed. Stephen Bainbridge, a law professor at UCLA, provides a legal viewpoint on his website

Gordon Gekko might have been right in the first place.

 Scannell, K. (2012), FBI casts Wall Street’s Gekko to remind traders greed is no good, Financial Times, February 28 2012
Bhattacharya, U. and H. Daouk (2002), The World Price of Insider Trading, Journal of Finance 62, 1 (February) 75-108
Leland, H. (2002) Insider Trading: Should It be Prohibited?, Journal of Political Economy 100, 4, 859-887
Meulbroek, L. (1992) An Empirical Analysis of Illegal Insider Trading, Journal of Finance 47, 7 (December) 1661-1699

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