The issues surrounding insider trading are contentious. To design an efficient and fair regulatory system, a deeper analysis is needed of the pattern and circumstances of the trading to assess whether and when insiders benefit or harm financial markets by buying or selling shares in their own companies.
A quick search of recently reported financial news reveals that the occurrence of insider trading increased from 336 cases in 2008/9 to 668 in 2009/10, then receded to 575 in 2010/11 and 360 in 2011/12.
While many cases relate to allegedly fraudulent “external” insiders with privileged information, a large amount of insider trading is undertaken by insiders themselves, that is individuals who are most likely to have private information about the future prospects of the firm.
From an academic perspective, research has focused on the timing of insiders’ trades, their gains when these trades are based on private information and whether outside investors can mimic such trades to gain excess returns.
Studies by public policy makers, regulators and academics ask the question whether insider trading is detrimental to the hypothesis of market efficiency or does it in fact strengthen the market?
In the first case, insider trading is a form of cheating as it is considered to be a transfer of wealth from uninformed to informed investors, with the likely consequences of reducing the propensity of outside investors to own shares. Thus, it should be regulated.
This suggests that sell trades should be legal while buy trades should constitute a violation of market abuse rules
But in the second case, insider trading is beneficial as it increases market efficiency and is likely to be driven by the insiders’ ability to recognise pricing errors made by outside investors trading against market sentiment. These arguments suggest that insiders should be encouraged to trade to convey more information to the market about the future prospects of their firm.
From a legal and policy maker’s perspective, the challenge is to define a set of rules that minimise the costs and maximise the benefits of trading on insider information. These rules should be enforceable without reducing managerial incentives to increase market efficiency and to make decisions that create wealth for the shareholders.
Although many countries have designed relatively strict insider trading rules, usually with different definitions of who is an insider and what constitutes insider trading, their enforcement is questionable.
Recent debate suggests that sell trades by insiders should be deregulated because these signal that the company is overvalued and the subsequent share price will decrease to a more realistic level.
If insiders are not allowed to sell, their firm will carry on being overvalued and the managers will be inclined to make poor decisions, such as overpaying for takeovers with their overvalued equity.
In contrast, buy trades should be regulated because preventing insiders from buying shares will not harm the firm’s future prospects even though insiders would like to signal to the market that their company is undervalued.
This suggests that sell trades should be legal while buy trades should constitute a violation of market abuse rules.
The difference between fraudulent and legal insider trading also relates to a distinction between the two main motives underlying the activity - trading before any material news is announced, and trading for market mispricing of the securities, liquidity and portfolio diversification considerations.
The regulator needs to assess the timing of the trades in relation to subsequent news announcements by the company. Although there is a blackout period, such as the 30-day restriction before earnings announcements, insiders may be tempted to buy (or sell) shares when they expect good (or bad) news.
The task then is to find out whether the insider was aware of this news. For example, in the case of a takeover announcement, where some substantial gains can be made, an insider can easily claim they did not know about it when the trade was undertaken.