Are securities law and their enforcement effective at mitigating market manipulation activities, especially insider trading activities? The study ‘Exchange Trading Rules, Surveillance and Suspected Insider Trading’, forthcoming in the Journal of Corporate Finance, tries to answer this question with unique international data and a natural experiment. For the first time, we examine the exchange trading rules that govern market conduct and relate these rules to insider trading. We use exchange trading rule changes in Europe as a natural experiment to ascertain the impact of trading rules on suspected insider trading. Further, we make use of unique surveillance data in relation to suspected insider trading and market manipulation activities.

One important aspect of this paper involves the broad nature of insider trading and its detection. Insider trading can be obfuscated by other forms of prohibited trading behaviours in particular market manipulation. For example, spoofing (which involves giving up priority), and bait and switch (which involves layering of the order book to impact price in a particular direction), can be used to make insider trading more difficult to detect. Similarly, volume manipulation through churning and wash trades can likewise make the detection of insider trading more difficult. Therefore, the ability of an exchange to mitigate insider trading activity and profits from insider trading depend significantly on the overall rule structure of the exchange and the ability of the exchange to detect manipulation in all its forms through domestic and cross-market surveillance. Prior studies on insider trading activities either only looked at the insider trading rules in isolation or do not consider market manipulation rules and/or complementarities across different types of market manipulation rules, and do not consider differences in surveillance.

An equally important aspect of this study is the difference between exchange trading rules and surveillance. Exchange trading rules are precisely known by market participants since they are very visible on each exchange’s webpage. Surveillance, by contrast, is not precisely known, but can be estimated. If market participants knew exactly what surveillance authorities did and did not have by way of alerts (computer algorithms to detect prohibited trading behaviors), then they could trade in precise ways to avoid detection. Rules and surveillance, therefore, have the potential to increase the profit level at which it becomes rational to commit a crime according to Becker’s (1968) economic model of crime (commit a crime if the expected benefits exceed the costs.)

The sample data used in the study come from Capital Markets CRC (CMCRC). Based on the unique, and in some dimensions proprietary access, we built a monthly dataset from 22 exchanges in 17 countries, including Australia, Canada, China, Germany, Hong Kong, India, Japan, Malaysia, New Zealand, Norway, Singapore, South Korea, Sweden, Switzerland, Taiwan, the United Kingdom (UK), and the United States (US) for the period January 2003 through June 2011.

Through the analysis of monthly data, our study uncovers a non-trivial role for exchange trading rules and surveillance in reducing the number of insider trading cases, but increasing average profits per case. In the most conservative estimates, a 1-standard-deviation improvement in trading rule specificity gives rise to a 23.43% reduction in the number of suspected insider trading cases and a 53.17% increase in profits per case. Overall, the findings highlight complementarities across different trading rules and surveillance, and these complementarities are at least twice as important as stand-alone insider trading rules for predicting the frequency of suspected insider trading cases. However, the complementarities are less economically important for predicting the trading value surrounding the suspected insider trading cases relative to stand-alone insider trading rules.

This paper is the first of its kind to examine exchange trading rules and relates these rules to insider trading. This study extends our understanding of the effect of different yet complementary market manipulation rules and policy mechanisms directly relevant to insider trading activities.

This post comes to us from Mike Aitken, Professor at the Australian School of Business, University of New South Wales, Douglas Cumming, Professor and Ontario Research Chair at the York University – Schulich School of Business and Feng Zhan, Assistant Professor of Finance at the John Carroll University – Boler School of Business. This post is based on their recent article, which is entitled “Exchange Trading Rules, Surveillance, and Suspected Insider Trading” and is available here.