In a new article, I use network theory to show that there is a hidden link between insider trading and macroeconomic risk. I suggest that current laws on insider trading increase the level of macroeconomic risk for the economy, and I show that this problem can be addressed by banning what I call network trades: trades based on private material information in firms that are connected to the firm of the insider (e.g. suppliers and competitors).
We live in an interconnected economy where private material information about one firm is also a relevant predictor of the performance of connected firms like suppliers, customers and competitors. Apple is a recent example of this dynamic. At the beginning of 2019, Apple revealed that its revenues were 10 percent lower than expected. As a result, there was a sudden drop in its share price (the largest one-day drop in six years), and in the share price of its suppliers (e.g. Cirrus Logic, Qorvo, Lumentum and AMS) and customers (e.g. Best Buy).
An Apple insider could have profited by short-selling the stocks of Apple’s suppliers and customers before releasing the information to the public. The key question is: Why would this dynamic have macroeconomic consequences? The answer has two parts.
First, insiders have incentives to engage in risky strategies so that they can profit from network trades. The reason is straightforward: Safe bets do not cause fluctuations in stock prices and therefore do not produce information on which an insider can profit. By contrast, risky investments will produce large fluctuations in stock prices. An insider can then profit by buying the stocks of connected firms if the project has a positive outcome, or by short-selling such stocks if the project is unsuccessful.
Second, research by network economists has produced two important results. On the one hand, that research identifies a relatively small number of central industries that account for most of the macroeconomic risk for the U.S. economy (Carvalho 2014; Acemoglu et al. 2017). That is, a shock to one of these central sectors is more likely to have a large impact on the entire economic system. On the other hand, these central sectors produce larger spillovers to neighboring industries, and therefore insiders can reap larger profits by creating risk in central sectors (Aobdia et al 2014). In other words, insiders of central firms can generate more risk and profit more from risk creation.
To be sure, one could acknowledge that local shocks can have macroeconomic consequences and still be skeptical that the decisions of one insider at a central firm can produce shocks big enough to have macroeconomic consequences. But the claim of this article is not that a single decision of a single insider at a single central firm will produce macroeconomic consequences. I do argue that network trades skew the preferences of many insiders toward more risk-taking in all central firms, and the effects of those decisions will ripple through the economy by way of various links. At times, these ripples will compound and trigger macroeconomic fluctuations.
Consider a comparison with bailouts to systemically important firms. It is well-known that the prospect of a bailout induces insiders of systemically important firms to engage in excessively risky behavior that in turn increases the level of systemic risk. However, this is not because the actions of a single insider of a single systemically important firm can trigger an economic meltdown. As in the case of network trades, bailouts give many agents that play a key role in systemically important firms widespread incentives to engage in excessively risky behavior. This is what increases the level of risk for the economy. There is, however, one fundamental difference. While there are strong reasons to bail out systemically important firms, there are no equally strong arguments to protect the ability of insiders of central firms to engage in network trades.
For these reasons, I argue that network trades should be regulated. More specifically, I suggest that network trades on private material information should be banned, at least in the most central sectors, and that the rule requiring insiders to disgorge short-term profits when trading in the stocks of their corporations should also be extended to network trades. I also discuss how to define the concept of network trade in clear and simple ways.
Acemoglu, Daron, Asuman Ozdaglar, and Alireza Tahbaz-Salehi. “Microeconomic origins of macroeconomic tail risks.” American Economic Review 107.1 (2017): 54-108.
Aobdia, Daniel, Judson Caskey, and N. Bugra Ozel. “Inter-industry network structure and the cross-predictability of earnings and stock returns.” Review of Accounting Studies 19.3 (2014): 1191-1224.
Carvalho, Vasco M. “From micro to macro via production networks.” Journal of Economic Perspectives 28.4 (2014): 23-48.
This post comes to us from Alessandro Romano, a JSD candidate at Yale Law School and former professor at the China-EU School of Law. It is based on his article, “Insider Trading and Macroeconomic Risk,” available here.