Despite losing several high-profile cases, the U.S. Securities and Exchange commission (SEC) has committed itself to prosecuting insider trading, outlawed by a patchwork of rule-making and court decisions. In recent years, the SEC has filed record-numbers of insider trading actions, totaling hundreds of cases. To increase the success of these prosecutions, much attention has focused on shoring up the legal framework on insider trading, described by many as ambiguous. However, attention should also be paid to how to catch insider trading based on an empirical analysis of insider trading.
This is the subject of our new article, which provides an empirical examination of the impact of insider trading on market performance and price distortion. We employ a dataset generated from SEC litigation releases, using a series of time-stamped trades prosecuted by the SEC to generate data files for both daily trading and intraday trading intervals. This data provides a natural experiment to examine the effects of insider behavior as the prosecution provides an ex post identification of insider trading within the larger pool of liquidity trades. In all the cases, the defendants traded on the basis of inside information, contravening federal law. The defendants are either ‘insiders,’ corporate officers who received private information in the course of their duties, or those who had been informed by corporate officers but do not have a duty to the corporation.
To aid prosecution of insider trading, we examine whether changes can be measured that capture the presence of an insider in the market, and how the market responds to the insider’s activity. Existing literature contends that in the presence of an insider, market participants will increase the spread to compensate for adverse selection, and this may lead to increased price movement on a trade-by-trade level as market orders absorb this increased cost.
The sample is composed of shares from NASDAQ, AMEX, the New York Stock Exchange, and over the counter (OTC) markets, which allows for an examination of insider behavior within different market structures. Daily analysis is initially performed to examine whether conclusions drawn in previous literature are idiosyncratic to samples. The analysis is then extended to intraday data to permit examination of trader behaviors both by insiders and uninformed traders as the trades occur.
Analyzing the dataset, we find that trades are different from surrounding trades in both trade to trade price impact and trade lot volume, information that should aid the government in identifying and prosecuting insider trading. At the micro level, insider trades are significantly different from surrounding trades in both trade to trade price impact and trade lot volume, when compared with trades executed in the same thirty minute interval by other traders. The size and volume effect is most pronounced on the two specialist exchanges of the American Stock Exchange (AMEX) and the New York Stock Exchange (NYSE). Trade to trade price movements are statistically significant at the 1% level for the panel of NYSE and AMEX shares.
While insider trades possess attributes that differentiate them from surrounding trades, a great deal of those attributes depends on the trade characteristics – aggressive market orders will draw scrutiny due to their price impact, whereas limit orders are less noticeable. Insiders trade lot sizes that are also larger than other market participants at the time, thereby potentially drawing attention from regulators and surveillance departments.
The law and economics of insider trading continues to develop. On the legal side, there has been pressure to clarify the legal framework. On the economics side, there has been work done to examine the impact of insider trading on the markets. We hope to contribute by offering an empirical examination of the impact of insider trading on market performance and price distortion in order to aid the government in identifying and prosecuting insider trading.
 Mitchell A. Agee, Friends in Low Places: How the Law Should Treat Friends in Insider Trading Cases, 7 Charleston L. Rev. 345 (2013); Gibson Dunn, 2012 Year-End Securities Enforcement Update, available at http://www.gibsondunn.com/publications/pages/2012YearEnd-Securities-Enforcement-Update.aspx. See also Miriam H. Baer, Choosing Punishment, 92 B.U. L. Rev. 577, 610 (2012) (“[The] SEC had always portrayed itself as a punisher where insider trading was concerned.”).
The preceding post comes to us from Margaret Ryznar, Associate Professor of Law at Indiana University McKinney School of Law and Frank Sensenbrenner, Fellow, Johns Hopkins University – Paul H. Nitze School of Advanced International Studies (SAIS), PhD in Finance, University of Sydney (not pictured). It is based on their paper available here, which is entitled “The Law and Economics of Insider Trading” and is forthcoming in the Wake Forest Law Review.