Last week we cited some of the more liberal interpretations of insider trading laws, including those which suggested that insider trading actually enables greater market efficiency.
I had noted that perceived fairness is a fundamental tenet of markets, so even in the absence of academic evidence about whether insider trading affects the markets adversely or not, markets need to be regulated strongly. Strong regulation implies very clearly defined rules covering a range of situations because capital markets operate in an information grey zone.
By definition, the entire securities market runs because there is information that is not in the public domain. Finance theory operates on the so-called semi-strong version of market efficiency, which implies that there is always some useful information that markets do not know and people try to find out. The analyst fraternity seeks to obtain such information from people who are either insiders or have access to information from insiders. Their profession works long days, has rolodexes with hundreds of contacts and manages millions of dollars of research budgets, only to get some edge that others do not have. In doing so, they may sometimes obtain information from designers, lawyers, building contractors, distributors and vendors who, in turn, would ultimately have received it from the procurement manager, the marketing head, the legal chief, etc. The arrest of the Galleon executives does raise some questions, namely, how far should fund managers and analysts go to beat the market. It also does highlight the fact that benefiting from both giving and receiving insider information is hugely prevalent.
A study in the UK suggests that 30% of takeovers were preceded by suspicious trading. In India too, if one examines prices of many stocks prior to takeover announcements, one will frequently find run-ups in that price, which could not have happened but for insider information leaking into the market. When capital markets are supported by an entire profession based on such preferential access to information, there will always be the risk that a significant number of trades will walk the line between legal and illegal activities. It is here that greater precision is required in the regulation.
When this is the institutional framework within which most markets work, then, almost by definition, a large number of trades could in some way be suspect. No one is suggesting for a moment that insider trading is not illegal. What one is suggesting is that more investigations be initiated by regulators, so that we can set clearer boundaries which will enable market participants to know what is right and wrong. It may be possible for a sample of transactions above a certain size to be looked at even more closely, even if there is no obvious suspicion of insider trading, to examine whether those who transacted might have access to insider information. Furthermore, it may be possible to say that information obtained legally from certain types of market participants cannot be used for trading for a certain period, say a month, so that very short-term trades taking place on illegal information are disincentivized. While one is not suggesting that the Securities and Exchange Board of India, or Sebi, resort to telephone tapping as in the Galleon case, it certainly could use technology more actively to identify and track a greater number of questionable transactions to their logical conclusion. While granting that it is difficult to prove complicity in insider trading cases, even being placed under investigation can prove a deterrent to such activity.
On a different note, an overwhelming focus on insider trading is on corporate executives and the information they have. Company executives are not the only ones with privileged information. Vendors of companies can have deep insight into their plans. Distributors of companies usually have information about sales performance even before the company does. Designers, lawyers and scientists who indirectly deal with the company can have a view of what is happening in the company, often comparable with that of insiders. Almost anyone who has traded in the market would be aware of the frenzied sharing of information that tends to take place when such people meet each other.
That such information is frequently untrue is not relevant to this argument. What is material is the fact that the information is felt to have been obtained from some authentic source, perhaps even one with a fiduciary responsibility. One wonders whether the regulators would seek to investigate more transactions where such groups of individuals are also involved, as this would then make the meaning of this law more inclusive. The intent of this article is not to recommend that the regulator move to a draconian dispensation.
However, given that various informational asymmetry related practices prevail in the market, and not all of these appear to be clearly covered by the law, we should increase the number of cases investigated so that a body of rules exists that defines the contours of acceptable behaviour in the market. Establishing the rules of the game in this manner can only help motivate all fair market participants, enhance retail market participation, and ultimately create greater depth in the market.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes every other Friday on issues related to governance. The views expressed here are personal. Write to him at email@example.com