The venue for stock trading is important. Exchanges provide high immediacy and transparency, while dark markets are slower and more opaque.[1] Traders generally prefer exchanges when they want to capitalize on information before it becomes known but value dark markets when they want to conceal information from others.
For corporate insiders, the choice between exchanges and dark markets can be especially important. They often have access to confidential and material information about their firms, and trading on it is generally prohibited. They must disclose all their trades promptly and are barred from trading during “blackout periods.” Although insiders eager for big returns may be tempted to violate these requirements, the consequences of getting caught are severe.
In a recent paper, we conduct a two-stage analysis of the factors influencing insiders’ choice of stock-trading venue and the impact of that choice on abnormal returns. The analysis is based on a sample of insider trades in Swedish stocks from 2016 to 2023. The data, obtained from the Swedish supervisory authority, consist of self-reported insider trades. A key element of our analysis is the requirement for insiders to disclose the venues where they trade. Our empirical approach defines insiders as informed when they display opportunistic behavior — such as not trading in a routine manner, as outlined in Cohen, Malloy, and Pomorski [2], or when engaging in large-volume trades. Additionally, we identify insiders who violate trading restrictions when they fail to disclose trades promptly or trade during blackout periods.
In the first stage of the analysis, we examine how insiders’ venue choices are related to whether they are informed and whether they violate trading restrictions. We hypothesize that informed insiders are less likely to trade on dark markets, while those violating restrictions are more inclined to do so. Trading on exchanges provides immediacy and transparency, whereas trading on dark markets offers opacity but sacrifices certain execution. Informed insiders typically want to trade quickly, as the cost of waiting increases with the value of the information and the uncertainty about when the price of a stock will reflect that information. In contrast, insiders who violate trading restrictions aim to conceal their trading, and their desire to trade is less urgent.
We find that insiders are less likely to trade on dark markets when they are informed and more likely to do so when they violate trading restrictions. The factors influencing insiders’ venue choices have significant economic implications. During our sample period, 18 percent of insider trading volume occurred on dark markets. Engaging in opportunistic trading or trading large volumes reduces the likelihood of insiders trading on dark markets by 5 percent. Conversely, trading during blackout periods or delaying trade disclosures increases the likelihood of dark market trading by 11 percent and 19 percent, respectively.
In the second stage, we examine how venue choice affects insiders’ abnormal returns. Venue choice is endogenous to insiders’ possession of information and their adherence to trading restrictions, which influences their venue choice and subsequent return. Given this fact, we hypothesize that insiders receive lower abnormal returns when trading on dark markets. This hypothesis is driven by the assumption that informed insiders prioritize immediacy on exchanges over the lower price impact on dark markets, leading to lower returns when they attempt to conceal their actions.
Our results show that trading on dark markets is associated with a 5 percent decrease in insiders’ abnormal returns.[3] This finding is economically significant, given that insiders’ average unconditional abnormal return is -1 percent. Thus, our results support the idea that venue selection is endogenous to abnormal returns, as informed insiders tend to choose exchange trading, leading to a negative correlation between trading on dark markets and returns.
Regulators have expressed concerns about the potential overuse of venues that offer concealment, as this could impede price discovery. Recently, regulatory discussions have focused on implementing rules to shift trading volume from opaque venues to more transparent ones. According to the European Securities and Markets Authority [4], nearly half of all stock trading volume in Europe occurs on dark markets. Our findings suggest that large volumes on dark markets are unlikely to impede price discovery, as informed traders tend to trade on exchanges to avoid missing profitable opportunities. However, there is a risk to market integrity, as insiders are more likely to use dark markets to conceal illegal activities. The opacity of dark markets makes it easier for them to evade detection and accountability, potentially undermining fairness and trust in the market. This risk highlights the importance of regulations aimed at safeguarding market integrity by preventing the misuse of dark markets.
In Europe, insider trading regulation is overseen by local financial authorities under the EU’s harmonized legislation, known as the Market Abuse Regulation (MAR). Insiders are defined as employees who have access to inside information, meaning non-public, price-relevant information. Similarly, in the United States, Rule 10b-5 classifies employees, stockholders with a 10 percent stake in the firm, or anyone with access to inside information as an insider. Insider trading is generally prohibited, and while both MAR and Rule 10b-5 aim to minimize it, they differ in their specific definitions and restrictions.
Rule 10b-5 defines insider trading as trading based on information that violates a duty of trust or confidence. For example, in the 2014 Newman case, two hedge fund managers were charged with insider trading based on tips from insiders. To be convicted, the insider providing the tip must have a fiduciary duty and must breach that duty by disclosing inside information for personal gain. Additionally, the recipient of the tip must be aware of this breach when trading. The fund managers were found not guilty of insider trading because the inside information had passed through several intermediaries, distancing the managers from the original insider, and there was no evidence of compensation for the tips (Berman, Conceicao, Gatti, and O’Neil, [5]). In contrast, under MAR, a violation of trust or confidence is not required for a conviction. A person who trades on inside information, with full awareness of its nature, can be found guilty of insider trading regardless of how they acquired the information.
MAR and Rule 10b-5 both impose restrictions on insider trading, but they differ in their approach. In the EU, insiders are prohibited from trading during the 30 days preceding an earnings announcement – a blackout period. The purpose of this restriction is to reduce the risk of insiders trading when they are likely to possess non-public information about the upcoming earnings announcement as the date approaches. In contrast, Rule 10b-5 does not mandate a blackout period; instead, it is left to U.S. companies to decide whether to impose such restrictions on insiders. Bettis, Coles, and Lemmon [6] report that over 92 percent of U.S. companies have policies that prohibit insiders from trading during specific periods.
Insiders are required to disclose any trades they make. In Europe, insiders must report their transactions to the local financial authority within three business days, while in the United States, insiders must report their transactions within two business days. Both EU and U.S. insider reports provide details such as the financial instrument involved, the type of transaction, the average daily transaction price, the transaction date, the reporting date, and the employee’s status. Additionally, MAR requires EU insiders to report their choice of trading venue. This venue reporting allows us to analyze insiders’ venue choices in detail. Therefore, we recommend amending U.S. disclosure to include the reporting of trading venues. This change would benefit researchers, who could study where U.S. corporate insiders trade, and U.S. supervisory authorities, providing them with a more comprehensive view of insider trading activities.
ENDNOTES
[1] Previously, most countries had rules mandating that trades should be executed on each national exchange. However, in Europe, the Markets in Financial Instruments Directive (MiFID) introduction in 2007 removed such rules to promote competition for order flow with transparency requirements for trading venues’ quotes and related depth, exempting some venues from pre-trade transparency. Similar events in the United States transpired with the introduction of the Regulation National Market System (Reg NMS) in 2007. We define dark markets as mechanisms that operate without or with limited pre-trade transparency, such as dark pools, systematic internalizers, and over-the-counter markets. Conversely, by exchanges, we mean mechanisms with full pre-trade transparency.
[2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1692517
[3] We measure the abnormal return over a 30-day period subsequent to each insider transaction. See the full paper for details.
[4] https://www.esma.europa.eu/press-news/esma-news/esma-publishes-its-2020-annual-report
[5] https://www.cliffordchance.com/briefings/2015/06/the_us_and_eu_anoceanapartoninsiderdealin.html
[6] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=76649
This post comes to us from Alexander Hübbert, a PhD student at Stockholm Business School, and Lars L. Nordén, a professor of finance at Stockholm Business School. It is based on their recent paper, “Bright Light, Dark Room: Where do Corporate Insiders Trade?” available here.