The mechanism of stock markets and how they operate
The term ‘stock exchange’ refers to the market involved in the buying and selling of shares and securities through agents who operate on orders from clients. The agents, paid commissions for their work, can access information on the market, current quotations, and expert advice, and they use this as the basis to help investors make the right decisions. Both the stocks and bonds are transacted in the stock market. Usually, agents, buyers, and sellers are not only the stock exchange market but also news agencies that operate there.
Stock markets are not influenced by the forces of supply and demand and have a very sensitive market structure. Complicated business problems, market challenges, financial needs, and the need to make technical improvements lead to rapid changes in the stock markets. Many challenges mean that maintaining stability is difficult. Moreover, floor trading and its mechanics are being transformed by changes in telecommunication and computer technology. The old modern nature of markets is determined by the developments such as technological or economical ones. In the United States, agents incorporate the orders (by customers) on forms known as the official ticket. The order is compared with the stock exchange agent of the other part and to let the client be aware of the progress of the selling or buying of their shares.
The role of inside information on the stock market
One of the most well-known and cited reasons for the regulation against insider trading is that it results in the reduction of investor confidence when the development of fair and orderly markets is jeopardized. Insider trading has also been viewed as immoral and against “good business ethics”, this being another justification for the claim against insider dealing. Insider trading may impair the allocative efficiency of financial markets. Other impacts of insider trading that have influenced the formulation of regulation against it include its ability to reduce market liquidity and increase the cost of capital. It is very well known to the public and is the most recognizable form of crime in stock markets.
There has been continued debate on whether insider trading is wrong, and whether it should be sanctioned and prohibited. There is no consensus to that extent. Politics have thrived on the context of insider trading and there is no doubt that insider trading has impacted the way stock market business is carried out. Continued lack of consensus regarding insider trading is a hindrance towards achieving effective economic policies related to this occurrence. Insider trading has been regulated with or without governmental regulation.
A lot of educative literature on the topic has helped in the evolution of the perception held by lawmakers, policymakers, and the general public as a whole. This justifies the exploration of this subject in this paper to help in the identification of the impacts of insider trading on stock markets and how it works, how justified the regulators are in their imposition against insider trading, the case against regulation of insider trading, and what can be done about the current situation since it has already been established that there is no consensus on this subject matter. There is evidence that gaining consensus either in practical or theoretical perspectives may take a long while and that it is a complex process regarding the already existing divisions. Yet consensus is important and beneficial, especially as regards the regulation and practice of insider trading. A consensus, for example, may be drawn into consideration of all the possible impacts (both positive and negative) of insider trading, because the lack of consensus is itself a problem in that it limits the making of effective economic policies regarding the subject matter.
Rules which prohibit trading on insider information exist in virtually every country with the imposition of criminal sanctions in a majority of the cases. There has been a case against regulation of insider trading, with deregulators arguing that there has been a misconception of the rationale, method, and scope of regulation. A point of disagreement exists regarding the property rights of the company, its information, and its use in the exploitation of the market. Deregulators support the use of the information to exploit markets as a way to reward entrepreneurs and managers. The opponents of the regulation for insider trading argue that insider trading does not hurt the investors, shareholders, or corporations. In addition, it has been argued by opponents against regulation that it is not possible to enforce a rule against insider dealing. They have also argued that the practice promotes market allocative efficiency. One of the reasons that might have caused opposition against insider trading regulation is that the argument is incomplete or unconvincing. Moreover, there is a case against the use of economic justification to regulate insider trading even when they are credible. Economic arguments against insider dealing should not be deterministic as MacVea observes, because other non-economic issues such as honest and fair markets as well as investor protection may prevail over the economic considerations or at least rank alongside them.
Insider trading may be used to expose information that is not disclosed in financial statements and this reduces or eliminates financial asymmetries existing in stock markets or any other markets. One of the most important pieces of information about a company, namely, its current financial status, is not reflected in the financial statements, and insider information may be used in this regard.
Insider trading as a problem and why it is regulated
There is evidence that information such as earnings has been leaked before the announcement day. Insider trading has been regarded as immoral and the war against it as a holy war. Allocative efficiency is a status where the resources, whether belonging to a state or an organization, are channeled to the best use. There is evidence that the availability of information and the proper use of this information is paramount to the allocation of resources. This is because investors can determine which companies to invest in or not. However, usage of insider information is regarded as dangerous, because companies undertaking new projects may be forced to shelve them if they realize or anticipate by any means that there will be a hostile response in the market. In addition, managers may be forced to factor in the likely reaction to, and the assessment of the project, which therefore affects the share prices.
It must be also considered that true or untrue information may be released about a particular company or issue, which may lead to adverse effects where underserved projects may otherwise be funded in favor of the deserved ones, which are in turn shelved. A real case must be put to regulate insider trading because of the possibility of the use of wrong or untrue information. While true information may be desirable because of its advantages, untrue information may lead to jeopardy.
Although it may be argued that insider trading may assist in the release of information and make it available (as an alternative method of information disclosure), it should also be noted that it is an inefficient method to disclose information, not only because there is the possibility of giving untrue information. Disclosure of information about a company is costly and at times the benefits (smoothing the market) might not match the costs. The market’s efficiency of operation may also be negatively affected by insider trading, because it may lead to reducing the accuracy of the pricing of securities, once analysts are discouraged to seek out information independently. The lack of seeking information independently may result when insider trading succeeds in signaling to traders the “true” value of the stock in question. Moreover, there is the possibility that insiders may be free to manipulate corporate disclosure if the prohibition of insider trading is relaxed. The case for regulation of insider trading may not have been complete, convincing, or use overly narrow grounds to justify regulation against the practice.
One of the costs of insider trading is the violation of one’s moral beliefs or social norms, causing individuals to change in their behavior. People can change in the way they view themselves as moral being, and these informal costs due to insider trading may even be more influential than the cost of breaking the law. Costs are termed as internal when they influence an individual this way, while they become external when they influence society. Internal costs may for example lead to the deterioration of one’s public image. Furthermore, insider trading becomes a problem when it leads to violation of social norms, in that the line between acceptable and unacceptable behavior is broken. Insider trading gives an informational advantage to a select few in the marketplace and can therefore be deemed unfair because everyone should have equal access to information and the benefits of investing in securities. The uninformed group is harmed by this practice, and instability also occurs in the marketplace. Additionally, investor confidence decreases, because the uninformed party can no longer trust the price of the security as reflecting its true value. Insider trading may also cause “price-sensitive” investors to bear the cost if insiders use the company information to gain an unwarranted advantage.
Comparison of insider trading with other forms of market manipulation offenses
A free stock market is supposed to or expected to flow with natural or normal forces that control the buying and selling of shares without undue manipulations. Any forces injected to control or manipulate the flow of the prices and mechanism of the stock market renders it no longer a free and fair market. Moreover, manipulation of the market may lead to sudden unpredictable changes in prices or stock levels. The probability of market manipulation in the stock exchange is very high in any country regarding the people who can cause this to occur. These people include the financial media, large shareholders, accountants, market professionals, and top executives.
There are several reasons why people may want to manipulate the market. These include lowering the investors’ expectations. In this case, manipulators will either sell high or low. Manipulation may also be utilized as a means to sustain the expectations where the expectations are boosted or not discouraged through the use of bullish or bearish trends. Manipulation may also be applied as a technique to hide financial problems.
The techniques utilized in the stock market are to lure investors through building a false impression, baiting them with rhetoric such as the use of cognitive or emotional tricks, such as making them fearful, among others. In addition, financial manipulators may act to influence investment through telling plain lies or hiding the truth. The manipulators also utilize certain tools to deceive the investors, including direct market price manipulations, off-market fraudulent schemes, spin (heavy information bombing). This information may come from the media or analysts. In addition, they may hide the truth through utilizing selective information and smokescreens, over-complex operations that may be hard to understand, false news, and cooked accounts.
Insider trading is a form of crime where one buys or sells shares while in possession of confidential information; however, the other party to this transaction does not possess this information. Such inside information affects the value to be placed on the securities involved. The information may have been gotten by a person (for example a director, employee, or professional adviser of that company), or maybe provided by somebody indirectly from the company who is in an elevated position. This form of crime is just one among others in stock markets.
Other irregularities, apart from acquiring and using insider information, may also lead to a problem in the stock exchange. These irregularities include noise, pricing errors, and limits to arbitrage, which may all lead to volatility. Market irregularities in the stock exchange include a secret team interfering with the stock markets to achieve certain interests. This form of crime is different. It is secretive, unlike insider trading which may be practiced even with the knowledge of people because it is not eliminated in the market. Insiders may be wrongly led to invest while there is outside intervention. Speculators in the stock market may be fooled by artificial propping up the market, and investors are misled to invest in the belief that the market may continue to rise.
For access to financial and other information that could lead to benefits from insider trading, an individual needs to have a close connection to the elevated managers. This has been exemplified by the fact that insider trading crimes have involved the participation of prominent people.
Preventing insider trading problems
The first step towards tackling insider trading is the identification of this particular form of crime. The identification and definition of insider trading are necessary because not all believe that it is wrong. Once people start to disagree with regulation and imposition of laws against insider trading, then it becomes impossible to eliminate this form of crime. Its elimination has been difficult over time because some regard it as a crime or agree that it has negative impacts. There is evidence that the public would oppose the use of insider trading in general.
Some attempts have been employed to tackle insider trading as a crime. Hong Kong adopted the Securities Bill 1973 which was reverted to Securities Ordinance in 1974. Subsections (1), (2), (3) of Section 140 of the aforementioned Bill outlined the activities that were to be prohibited. Outlined in the prohibition was the use of price-sensitive information through the association of one’s informant with the company, or through the association of that individual with the company. Individuals violating others about insider trading were to be liable to the people who incurred losses by the gaining of advantage through the use of insider information. The person who gained the advantage would also be liable to the corporation issuing the securities. The regulation mandated the Commissioner to act to assist the individual or corporation that incurred loss to recover that loss.
As can be seen from the above, one of the strategies that could help in eliminating insider trading crime is the establishment of a regulation that deals with and avails for the punishment of these individuals. Preventing insider trading as a crime has been very difficult because evidence regarding the issue is very difficult to obtain, if not impossible. Securing a conviction regarding this fraudulent behavior is therefore challenging. A civil remedy has been proposed for dealing with this vice. The price of the company’s stock may depreciate once the public becomes aware of insider trading. Furthermore, the decline in the price may also be a benefit to new buyers who have fallen victim to insider trading.
The release of information from the company relates to the association of those interested in this information, with those who are holding this particular information. This relationship cannot be broken, but much can be done to prevent such practices as the use of insider information. Prevention of insider trading can be done through collaborative efforts among the involved stakeholders. It is evident that this form of crime is not easy to run away from because of its nature of secrecy. Because the use of insider trading as a practice contravenes morality (as discussed earlier), there is a need to ensure that those responsible for the information of any particular company are people of high morals. In addition, it is necessary to teach these morals to all people, especially those joining the companies, and to ensure that these are engraved in the company culture.
In the view that the use of insider information is a practice against the well-being of any company, there is a need for the companies themselves to initiate and adopt necessary procedures to curb the practice. Curbing the practice of use of insider information may be necessary for example where the company loses crucial information to outsiders, which may result in utilization of this information for other purposes rather than insider trading, such as damaging the structure of the company (for example marketing systems) and compromising the market of the shares through unfair means. Companies need to realize that there is a need to formulate rules and regulations that will regulate the release of insider information. Companies, in this way, will not only have to rely on the laws of the state or country that are there to curb the use of insider trading. Where such laws exist, there is a need to ensure that they are strengthened because they have not solved the problem. In establishing these rules and regulations, companies need to consider what is best for the stakeholders about the benefits and challenges of insider trading.
Stock exchanges have been marred with the problems of using insider information to trade. There is controversy as to whether insider trading is wrong or right, and this has invoked extensive debate regarding this issue. Controversy relating to insider trading has resulted in the lack of good policy to regulate it. Proponents of regulation against or prohibition of insider trading argue that the practice is dangerous because it has led to several problems, among them the unfairness amongst investors. Secondly, insider trading has been regarded as an immoral practice. In addition, the practice has been viewed as disrupting allocative efficiency, among other problems. Proponents of regulation of or prohibition of insider trading have not provided a convincing, complete, or satisfactory argument, and therefore it has not been agreed upon by every person. Opponents disagree on several issues posited by the proponents with regard to the fact that insider trading can lead to problems of allocative efficiency. Instead, the opponents argue that insider trading promotes allocative efficiency. Insider trading may be dangerous when wrong information is utilized to inform investors. Opponents of regulation against insider trading also claim that the use of information by the investors can help them to best determine when, where, and how to invest their monies. The practice has also been termed as another better way to dispatch information about a company, which is true because not all information about a company is released. Insider trading can therefore guide investors properly by letting them know the true current status of the company, and in fact, it can shield them against the utilization of untrue information that could be used in financial documents to lure them instead.
Stock markets have also been marred with other problems such as the influencing or manipulating of the investors to act in certain ways. Investors may wrongly be advised or influenced through the use of a variety of techniques, for example, the use of lies, cooked accounts, boosting of sale prices intentionally, and the use of cognitive manipulation among other techniques. The main difference between these tricks and insider trading is that insider trading is a hidden technique that is not prohibited fully, or which may be regulated by the legal provision but identified.
While insider trading may benefit some investors, some other techniques like manipulation may not benefit investors at all. However, the fight against insider trading may have influences such as greater averages in stock market turnover, lower equity ownership concentration, and more informative stock prices. Insider trading can be regulated through the legal framework. There is however evidence that it is not possible to eliminate this vice since it is not possible to provide evidence in a case in a court of law regarding the use of insider information. In addition, differences exist as to the legality or illegality of the issue, because all people do not agree. It has been proposed that if share repurchases are allowed, there should be no prohibition of insider trading.23 Consequently, there is a need for consensus regarding the regulation of the practice. A general direction regarding the establishment of regulation for or against the practice can be drawn due to the negative and the positive consequences of the practice.
Arshadi, Nasser., & Eyssell, Thomas, (1993) The law and finance of corporate insider trading: Theory and evidence. Boston: Kluwer.
Barry, Norman, ‘Witchcraft and insider dealing’ (1993) Insider Dealing, MacQueen, H. (ed.) Edinburgh: The David Hume Institute.
Benny, Laura, ‘Evidence on insider trading laws and stock markets’ (2006) Testimony before the United States Senate Committee on the Judiciary.
Bokhary, Kemal, ‘Insider dealing-identifying and tackling it’ (1984) 14 Hong Kong Law Journal.
Buffa, Andrea & Giovanna, Nicodano, ‘Should insider trading be prohibited when share repurchases are allowed?’ (2008) 12 Review of Finance, 735-765.
Hayek, Friedrich, ‘The use of knowledge in society’ (1945) 35 American Economics Review, 4, 519-30.
Levitt, Arthur, ‘A question of integrity: promoting investor confidence by fighting insider trading’ (1998). Remarks of Chairman Arthur Levitt to the ‘S.E.C. Speaks’ Conference.
Malone, Emily, ‘Insider trading: Why to commit the crime from a legal and psychological perspective’ (2004) 12 Journal of Law and Policy.
Manne, G, ‘In defense of insider trading’ (1966) Harvard Business Review, 44 (66): 113-122.
McVea, Harry, ‘What’s wrong with insider dealing?’ (1995) Legal Studies.
Moore, Jennifer, ‘What is really unethical about insider trading?’ (1990) 9 Journal of Business Ethics, 171.
Nuno, Fernandes, & Ferreira, Miguel, ‘Insider trading laws and stock price informativeness’ (2008) 22 The Review of Financial Studies, 5.
Padilla, Alexandre, ‘How do we think about insider trading? An economist’s perspective on the insider trading debate and its impact’ (2008) 4 Journal of Law, Eonomics & Policy, 2.
Painter, Richard, ‘Insider trading and the stock market thirty years later’ (2000) 50 Case Western Reserve Law Review.
Scheppele, Kim, ‘It’s just not right: The ethics of insider trading’ (1993) Law and Contemporary Problems, 123.
Shimizu, Katsutoshi, ‘Is the information produced in the stock market useful for depositors’ (2009) 6 Financial Research Letters, 34-39.
Taylor, H, ‘Differing perceptions of the guilt or innocence of Michael Jackson, Kobe Bryant and Martha Stewart. Harris Interactive’.
Wang, William, ‘Stock market insider trading: Victims, violators and remedies-including an analogy to fraud in the sale of a used car with a generic defect’ (2000) 45 Villanova Law Review, 27.