In India and around the world, a series of embarrassing insider trading scams have shaken the public’s trust in capital markets. Investors are getting increasingly sceptical as more and larger scams continue to be reported on the heels of the global financial crisis.
Insider trading has been prevalent since the inception of the stock markets. The US was the first to enforce legal prohibitions on it almost 50 years ago; others followed in the 1980s and 1990s. In India, the concept started fermenting in the 1980s and came to be observed extensively in the 1990s and 2000s.
The US Securities and Exchange Commission (SEC) defines insider trading as “the buying or selling of stocks and other securities while in possession of material, non-public information about the security”. Insider information would give one party an unfair advantage over other market players.
The phenomenon is under the scanner following high-profile cases investigated by SEC in the US and the Securities and Exchange Board of India (Sebi). The most recent is the multi-billion-dollar Galleon Group hedge fund scam, which has been called the biggest insider trading case in the US.
In this study, we will assess the broader impact of insider trading on the stock market and draw conclusions about the psyche of investors. We started by identifying a diverse set of countries—India, the US, France, Japan and Australia. We gathered 10-year data (2001-2010) on stock market indices and the number of insider trading incidents reported and investigated by the respective regulatory agencies in these countries. We looked at the absolute annual change in the stock market index as a standard basis for comparison across these markets. A ratio of “absolute annual change in the stock market index to the total number of insider trading incidents in that year” was calculated, that the authors term as the Insider Trading Sensitivity Index (ITSI). ITSI has the following properties:
(i) A high (or low) ratio indicates that the absolute change in the stock index is high (or low);
(ii) A high (or low) ratio could also mean that for the same change in the index, the number of incidents are low (or high); and
(iii) A low (or high) ratio can also be a result of very high (or low) incidents and a low change in the stock index.
Of the five countries considered, Australia had the highest number of insider trading incidents per year (73), followed by the US (52). Japan, India and France reported an average of 15-20 incidents a year.
The ITSI ratio for the five countries over the last 10 years shows an interesting pattern (see table). India has the highest ratio, followed by France, the US, Australia and Japan.
With all things equal or controlled for, the sensitivity index shows that anytime an insider trading incident is reported, the investing public in India appears to become more “rattled” than that in the other countries. Whereas, the Japanese investing public seems to be the least worried about insider trading reports.
One possible explanation is the level of confidence investors have in the capital markets and their belief that checks and balances exist (or don’t) in the regulatory systems to protect them.
Investors in the US, Australia and Japan may have more confidence in their regulatory framework, and may feel that their regulatory agencies will be able to properly prosecute such incidents and streamline processes to curb future ones.
However, investors in India, and to some extent those in France, may not have the same level of confidence and may worry that appropriate checks and balances are not in place to detect and prosecute such cases. In the Indian context for instance, even though Sebi has strengthened anti-insider trading laws since 2002, it has often failed to prove its cases due to alleged lack of evidence and investigative resources.
Perhaps there is also an ideological aspect to insider trading that could have a bearing on the sensitivity index. Though Japan enacted its first law against insider trading in 1988, “even today many Japanese do not understand why this is illegal. Indeed, previously it was regarded as common sense to make a profit from your knowledge”. (Roderick Seeman, Japan Law). This belief could partly explain the lower sensitivity index for Japan.
Compare this with France, where anti-insider trading efforts were considered consistent with the Gaullist ideal of linking “capital and work” in setting up a trend towards the diffusion of shares in the public. Accordingly, there appears to be a strong belief that individuals holding only a few shares should get the same information as the affluent investor. Hence France’s relatively higher score on the sensitivity index. This also seems to echo well with the Indian belief system. Despite recurring scams, India investors appear to expect a high moral ground from financial markets. This attitude could partly explain the higher sensitivity towards insider trading.
It appears that in addition to regulatory systems, the politics of insider trading is dominated by values aimed at controlling and restraining greed. Laws try to ensure fairness by minimizing unfair benefits and restoring a level playing field that is fundamental to capital markets.
Madhukar Angur & G Shainesh are, respectively, the chancellor of Alliance University, Bangalore, and professor of marketing at the Indian Institute of Management, Bangalore.
Illustration by Jayachandran/Mint; graphic by Yogesh Kumar/Mint
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