Thursday, May 26, 2011

Profitable Insider Trading..... Inside the Beltway

Washington Times -- "An extensive study released Wednesday in the journal Business and Politics found that the investments of members of the House of Representatives outperformed those of the average investor by 55 basis points per month, or 6 percent annually, suggesting that lawmakers are taking advantage of inside information to fatten their stock portfolios.

To the frustration of open-government advocates, lawmakers and their staff members largely have immunity from laws barring trading on insider knowledge that have sent many a private corporate chieftain to prison.

Strict laws ban corporate executives from trading on their insider knowledge, but no restrictions exist for members of Congress. Lawmakers are permitted to keep their holdings and trade shares on the market, as well as vote on legislation that could affect their portfolio values."

HT: Mike LaFaive

MP: How about we just "legalize it?"  Insider trading that is. 

50 Comments:

At 5/26/2011 7:59 AM, Blogger W.C. Varones said...

It is legal for Congress.

Insider trading laws are about material, nonpublic information from inside a company.

If you have material nonpublic, information about what Congress is going to do to a company or an industry, trade away!

There are two sets of rules: one for the Ruling Class and one for the rest of us.

 
At 5/26/2011 8:02 AM, Blogger Methinks said...

I'm all for decriminalizing insider trading. It's a dumb law that serves only to weaken the market, strengthen the government and increase the deadweight loss of regulation.

As if the law itself isn't bad enough, our overlords in congress (who already consider themselves in a class by themselves) are exempt. If it's such a hideous, dangerous and unfair thing, then why are our public leeches....I mean..servants allowed to do it? Rule of Law or Rule of Man?

 
At 5/26/2011 9:00 AM, Blogger morganovich said...

while i find it easy to believe in the cupidity of congress, this study demonstrates absolutely nothing.

this would only be meaningful if congressional members were average investors with average investing experience, education, etc.

i find that very difficult to believe.

further, they are likely to be better connected and know more businesspeople. that does not indicate insider trading, just better info.

not all good info is insider.

this is a very sloppily derived conclusion.

 
At 5/26/2011 9:16 AM, Blogger Methinks said...

Morganovich,


I do not for one moment believe that politicians in congress are great traders - regardless of how many smart people they may know.

However, the bigger issue is not how much or even whether they outperform. It's that they are exempt from insider trading laws.

Exempting everyone but a small group of people from restrictions creates rents for that small exempt group of people. Should we not demand that our public servants play by the same rules the impose on everyone else or should we be delighted that our public servants enrich themselves at our expense?

 
At 5/26/2011 10:35 AM, Blogger morganovich said...

methinks-

most people are terrible stock traders.

it's just a question of where congress sits in the bell curve.

my point was not to exonerate congress nor extol their virtues, but rather to point out that this study is making a claim that it cannot back up.

you'd need to compare them to say, heads of local chambers of commerce or some such.

congressmen in general get a great deal more information that a typical investor by virtue of knowing more and more influential people.

the same can be said of hedge fund managers.

this is not a de facto sign of insider trading. knowing things and knowing people who know things is not illegal, immoral, or bad in any way.

the line of "material nonpublic" is very different.

this study provides ZERO evidence that they crossed it or even that they outperform peers who have similar information (like business leaders)

also, 55bp a month compounds to 7 percent, not 6, so i'm left questioning the mathematical acumen behind this study. not realizing that you have to compound monthly gains to get annual is a pretty rudimentary mistake.

none of this exonerates congress in any way either, but this is a purely circumstantial argument made by choosing a poor comparator set.

on it's face, it proves nothing.

 
At 5/26/2011 10:48 AM, Blogger Methinks said...

Morganovich,

You put forth some good criticisms of that study. I won't argue with that.

Personally, that's not what bothers me.

The fact is that members of congress are exempt from insider trading rules. That, to me, is far more bothersome.

Whether they choose to exercise it or not, the option to trade on material inside information exists for congress. Options are valuable whether or not they are exercised or not. A bill to take that option away from them has been proposed several times. It has always been voted down by congress (shocking, I know!).

So, while congress retains that option for its members, it takes that option away from everyone else. We are poorer by one option. They are richer by one option.

As you know, I think the law is incredibly stupid. I'm happy to allow them to keep their option, but I want ours back.

 
At 5/26/2011 11:17 AM, Blogger Buddy R Pacifico said...

There are two separate issues here:

Insider trading rules don't apply to members of Congress.

Democrats are more successful traders.

Members of Congress should have the same rules on insider trading as anyone else. This situation is insidious and scandalous.



Democrats may be simply willing to take more risks in their investments. Republicans are probably more conservative in their investments.

Dems: Equities > Bonds/CDs

Pubs: Equities < Bonds/CDs

Note the study used data from pre-2008/09 equity plunge.

 
At 5/26/2011 11:36 AM, Blogger morganovich said...

methinks-

i think you may be overstating the position on congress.

they are not "exempt from insider trading".

many have to provide position disclosure.

this is a much lighter restriction than many government employees, but it's still more than an average citizen.

sure, they may come in contract with lots of inflrmation, some of it material nonpublic.

i wholeheartedly agree that they ought to be banned from trading equities in industries that they regulate.

i would even go so far as to say that i suspect that many do insider trade.

but they are not legally permitted to do so.

they are not exempt from the laws.

they have just never been prosecuted, which is a bit of a different.

it seems to me that you are actually taking issue with the structure of insider trading laws in general.

if i am an officer of a company, and i tell you we're going to beat the number for q2 and you trade on that, that is insider information.

if you tell you barber what i told you and he trades on it, it is no longer illegal. you are not an officer of the company and therefore information you pass on is not considered insider information.

the same is true if a competitor tells me they just took your biggest account. i am free to short your stock as the person who gave me the information is not an insider of the company whose stock i am trading. but i could not buy stock in the competitor than gave me the info.

it is precisely this tangled mess that makes our insider trading so impossible to sort out. there is no really cut and dry standard beyond direct disclosure from an officer.

congress falls into a similar situation. if they are going to pass a law, they can trade equities in affected companies. they are treated just like a competitor taking away a customer or launching a new competitive product.

they are not officers of the company. their information is not considered "inside" and more than barnes and noble knowing the will launch the nook is insider information about amazon.

i completely agree that it's not a perfectly analogous situation, but it is the same law being applied the same way. congress ought to restructure its ethics rules to prevent this, but the existing IT law is quite explicit on permitting this sort of activity for anyone, not just congress.

they are not getting a special deal, just using the same rules as everyone else.

 
At 5/26/2011 11:43 AM, Blogger bob wright said...

Methinks is right.

The issue isn't whether or not members of congress are good or bad traders. The issue isn't whether members of congress have access to powerful people with insider knowledge.

The issue is that congress has exempted itself from the law.

This would be a great topic for a blog: document all of the laws that congress has exempted itself from.

You could start with social security. It is my understanding that the U.S. congress does not participate in the SS program. Is this still the case?

 
At 5/26/2011 11:45 AM, Blogger bob wright said...

Morganovich,

If your definition of insider trading is correct, why did Martha Stewart go to jail?

 
At 5/26/2011 12:19 PM, Blogger morganovich said...

re martha:

because she received direct insider information from a corporate officer and traded on it.

even so, martha was incredibly stupid. if she had just pleaded out and paid her fine, she would have walked.

but she made a public spectacle and they pile drove her as a result.

 
At 5/26/2011 12:20 PM, Blogger morganovich said...

ironically, if the FDA had called her and told her the trial results, she likely would not have been convicatble.

but the fda staffer who leaked would be in deep trouble. they have draconian codes of conduct about that.

 
At 5/26/2011 12:39 PM, Blogger Methinks said...

Morganovich,

it seems to me that you are actually taking issue with the structure of insider trading laws in general.

Oh no, at bottom, I take issue with the very existence of the insider trading law, full stop.

It should not exist.

I think I do understand the insider trading law as I am regulated by the SEC and I have to comply with it. Yet, it is so mushy, that the best I can claim is an "understanding".

Here's what congressmen are allowed to do:

A member of congress sitting on an oversight committee is privy to information gathered by the committee he may trade on it.

To use one of your examples from a previous thread:

A CEO may not sell his company's stock the day before he knows he will be investigated by the SEC for fraud. An employee in the company may not do so either. The people running the investigation at the SEC can't. The lawyers for the CEO can't.

A member of congress sitting on the House Fiancial Services committee who learns of this impending investigation through the course of his work (just like the lawyers, the SEC agents and the CFO of the company) CAN.

Why?

The SEC currently has no authority to hold members of congress or the executive branch liable for using material non-public information gained from official proceedings.

I reiterate that I believe the law is bad for the market - not only in its current formulation but in ANY formulation.

I have no problem with companies creating and enforcing their own insider trading rules.

But, I do object also (as a separate objection) to the fact that the law exists for some and not for all.


BTW, I didn't know any of this until about two years ago and I've been in the securities industry for two decades.

 
At 5/26/2011 12:51 PM, Blogger Jason said...

"When the House does it, that means it is not illegal!"

 
At 5/26/2011 2:48 PM, Blogger morganovich said...

methinks-

i'm not sure i understand your position vis a vis congress.

if i find out that a company will miss their quarter because their customer who pulled his order tells me so, that is not technically insider trading.

this situation is analogous to a congressman finding out about an investigation from the SEC.

material nonpublic can only come from the company.

that's what a broker will force you to commit to being "over the wall" to tell you about a PIPE deal. if they don't, you could short based on expected dilution, cover on the deal, and it would be legal.

i agree with you that such examples clearly demonstrate just how foolish and arbitrary our insider trading laws have become, but i don't think it embodies any special treatment for congress.

regarding eliminating them altogether, that appeals to me on a free market basis, but i have never quite been able to get comfortable with the idea.

first off, it encourages extreme nepotism.

but worse, it creates some VERY perverse incentives.

if a CEO can sell before a missed quarter, then the whole equity compensation scheme gets sort of thrown out the window. it actually incentivises all manner of deliberate volatility and cookie jar accounting.

a ceo could get a customer to delay a contract into the next quarter, dump all his stock, then miss the quarter. he could then buy it back at a lower price, fold the contract into next q's number, beat it bigtime, ride the rally and profit.

repeat as needed.

he gets rich, his shareholders get whiplash.

is that really the sort of behavior we want to encourage?

i grant you that the existing laws are a muddle and filled with ugly gray areas, but replacing them with a free for all might well be worse.

i realize that some other markets allow it, but none that are major, and that may well be for a reason.

as an investor, do you want to have to trade against the CFO?

 
At 5/26/2011 3:41 PM, Blogger juandos said...

Wait a sec! Is this the same Congress (or at least a portion of them) who whine and rant and want to investigate speculators everytime there's a shift in the price of a commodity?

 
At 5/26/2011 3:43 PM, Blogger Methinks said...

Morganovich,

Just as an aside, I'm not at all certain that you are correct in your interpretation of the law. I think it's much broader and I think it's interpreted much more broadly by the SEC, but that's not the focus here. We're not lawyers.

This situation is analogous to a congressman finding out about an investigation from the SEC.

If the congressman in question found out from third hand, then maybe not (although, this, as I say above, is murky for me).

But, if the congressman happens to be a member of the House Financial Services committee and found out through official proceedings, then he is an insider.

material nonpublic can only come from the company.

This is not true. The SEC agents involved are not part of the company, but they are insiders. The outside council hired by the company is not part of the company but is an insider. Investment bankers putting together deals are considered insiders, but they are not part of the company.

I'll address the rest in a separate post as it's a substantially different subject.

 
At 5/26/2011 4:19 PM, Blogger Methinks said...

On decriminalizing Insider trading.

1.) strong efficient markets are those where all public and non-public information is known. Decriminalizing the non-public information will allow for that information to be priced in faster.

if a CEO can sell before a missed quarter, then the whole equity compensation scheme gets sort of thrown out the window. it actually incentivises all manner of deliberate volatility and cookie jar accounting.

Morganovich, you've been in this business too long to not understand exactly what will happen to that company's stock (and, ultimately, the CEO's job) if he runs the company in such a manner. The insider trading profits would have to be quite other worldly to make up for the disaster he causes running the company this way.

he gets rich, his shareholders get whiplash.

The price of the stock will decline to account for increased volatility. Nobody wants that.

I don't think he'll get rich either.

This, of course, depends on the potential edge (or profit) for insider traders.

Currently, the edge is quite large because its criminal status discourages competition. This is key.

However, the CEO is not the only person in the firm privy to the same insider information (usually, I find he's the last to know much of anything).

if insider trading is decriminalized, then the CEO will have competition from other insiders within the firm seeking to capture that edge by releasing trading on the insider information. We know what happens to edge (profits) in a competitive market - it declines.

So, in an environment where all insiders are free to compete with each other to trade on the information, the profit for insiders will be small. I think it will be fleeting and tiny (it's already not large for reasons I explained in an earlier reply on this topic on this blog. Which begs the questions why these fools seek these profits when the legal risk is so high, but that's another topic.).

The CEO will not get rich. It certainly won't be worth his while to run his company like a lunatic.

In your scenario, you didn't account for the punishment the market will inflict on the stock price for the erratic running of the company and you didn't account for the edge compression resulting from competition from other insiders. Thus, I believe you've got it wrong.

Meanwhile, shareholders are better off if insiders can trade. WorldCom perpetuated its fraud for 5 years before it was finally revealed. Insiders knew about the fraud, but could do nothing. That means, for five years, the WorldCom stock price was a fraud. This is not good for the market.

It was strange for me to think about this at first as well.

I do think it's a more complicated discussion because there may be very good reasons why companies want to have their own rules prohibiting insider trading and they should be absolutely free to have and enforce such rules.

Companies are in a better position to police insiders and punish them. Taxpayers and the rest of the industry should not be forced to bear the cost of dealing with insiders. However, companies will be able to do nothing at all to insiders who perfectly legally (if against the company's own rules) release information about fraud.

Now, I'll go post my reply to you about negative interest rates (which I wrote six phone calls and four "fires" ago but forgot to post).

 
At 5/26/2011 4:22 PM, Blogger PeakTrader said...

Why not give the answers to your tests only to the most privileged students and then grade on a curve with a "C" average?

Or in the unrealistic situation where everyone has equal access to insider information, you could give everyone a "C," or make grades dependent on how fast they cheat.

 
At 5/26/2011 4:39 PM, Blogger Methinks said...

Peak Trader,

What you describe is in no way analogous to insider trading.

 
At 5/26/2011 4:41 PM, Blogger PeakTrader said...

Methinks, you need to Methinks more.

 
At 5/26/2011 5:13 PM, Blogger Bernie Ecch said...

Instead of trying to ban it, make them disclose what they have so we can duplicate their performance

 
At 5/26/2011 5:22 PM, Blogger Methinks said...

Methinks, you need to Methinks more.

Entirely possible that I do (although, if I may suggest, leaving off the second "me" would have read better).

 
At 5/26/2011 5:32 PM, Blogger Methinks said...

No, Peak. I still don't see how your scenario is analogous. Could you explain?

 
At 5/26/2011 6:21 PM, Blogger PeakTrader said...

Methinks, the stock market is a zero sum game.

If the market rises 10% (after insider information is generally known, which is inevitable) and an insider trader makes 100%, then everyone else averages less than 10%.

 
At 5/26/2011 6:25 PM, Blogger Methinks said...

Peak,

Individual trades are zero-sum (and not only in the stock market). The stock market and trading in general is not zero-sum. I think this is the root of your mistake.

 
At 5/26/2011 6:29 PM, Blogger Bobby Caygeon said...

Methinks it might be in the best interest of methinks to let this one go.

 
At 5/26/2011 6:34 PM, Blogger PeakTrader said...

Methinks, are you saying when someone makes an above average return, then everyone else, on average, makes an average return?

 
At 5/26/2011 6:40 PM, Blogger Methinks said...

No, Peak, that's not what I'm saying.

Right now what I'm saying is that I think Bobby Caygeon has just given me some good advice.

 
At 5/27/2011 8:42 AM, Blogger morganovich said...

"Morganovich, you've been in this business too long to not understand exactly what will happen to that company's stock (and, ultimately, the CEO's job) if he runs the company in such a manner"

i've also been in this business too long to think that lots of them would not care. this might not be a big deal in IBM, but in the small and microcaps, it would lead to rampant theft.

"The price of the stock will decline to account for increased volatility. Nobody wants that."

wrong. that is exactly what the ceo who just sold all his stock wants so he can buy it back cheaply.

"
if insider trading is decriminalized, then the CEO will have competition from other insiders within the firm seeking to capture that edge by releasing trading on the insider information. We know what happens to edge (profits) in a competitive market - it declines"

creating the same moral hazard for all the employees, especially salespeople. if you are a little enterprise software co, this is a nightmare.

"In your scenario, you didn't account for the punishment the market will inflict on the stock price for the erratic running of the company and you didn't account for the edge compression resulting from competition from other insiders. "

actually, i was counting on that. it only makes the scenario worse and more profitable for the insiders to cheat.

also, you are assuming that you will know they did it. how can you know if a contract was supposed to close on june 30th or july 7th?

in many small enterprise companies, that's the difference between a made and a missed q.

also, your whole idea of "the insiders will create an efficient price" has a huge flaw - they already know the q. thus, they get out while making the price efficient and you, the shareholder, get soaked. is that really the system you want? they blow it and you pay while they sell high and buy back in?

"Insiders knew about the fraud, but could do nothing"

that's just flat out untrue. they were able to sell many, many times. every q had a window. they were not locked up for 5 years. most of the wcom employees did not know about the fraud. (and i did a lot of work on it as a short, so i speak from direct knowledge)

removing insider laws would not mitigate that kind of fraud.

it gets done at the C level.

and i think you are really underestimating the effect that decriminalizing IT has on equity incentives.

c level officers that are free to trade once they know the number become an extremely privileged class of investor. imagine how much money you could make if you knew every number from every quarter weeks ahead of publication.

this offends notions of fairness, disrupts the role of equity as an aligner of interests (as now you suffer from a missed quarter but the CFO profits - don't forget that you have already lost money by the time he makes the market "efficient" for you), and leads to an insanely slanted playing field that is literally equivalent to playing poker with an opponent who is allowed to look at your cards before he even deals them to you.

if you have an interest in such a poker game, bring your money. i'd love be the dealer. i suspect you may rapidly find that despite having "more efficient" betting, you dislike such a game intensely.

 
At 5/27/2011 8:45 AM, Blogger morganovich said...

"Peak Trader,

What you describe is in no way analogous to insider trading."

actually, i think his analogy has some merit.

if the management team and a few privileged inventors who golf with them get the answers ahead of time and get to profit from it while everyone else gets a "more efficient" C, it's quite a bit like that sort of system.

you wind up with 2 classes of investors (or students) and which one you are in determines a great deal about your performance.

the analogy is not precise because the "c" students do not benefit from any signal from the "a" students, but there is still some relevance.

 
At 5/27/2011 8:55 AM, Blogger George Phillies said...

Let me try a different variation on the theme:

In order to be elected to Congress, you really helps to be a multimillionaire. Running your own company is a full time job, hence a disadvantage.

There is a selection bias here. Lousy and non- investors are less likely to be Congressmen, though some inherited their money and didn't throw it away yet.

 
At 5/27/2011 9:02 AM, Blogger Methinks said...

if the management team and a few privileged inventors who golf with them get the answers ahead of time and get to profit from it while everyone else gets a "more efficient" C, it's quite a bit like that sort of system.

Morganovich,

Then this analogy applies to anyone with more education, talent, better algos and faster computers. Why single out inside information?

The playing field is not level.

As for performance...please read my earlier response to you. competitive markets are not characterized by excess returns.

 
At 5/27/2011 9:21 AM, Blogger Methinks said...

Here's another thought, Morganovich:

If you could legally buy the information off the insider, would you? I think you would. I would. information is valuable. You would rather make a trading decision after factoring in all information, wouldn't you?

Your objection (from an investor's/traders point of view) seems to be that you must pay the insider for information. But, you would expect to pay anyone for a valuable commodity. This feels different, but it isn't.

 
At 5/27/2011 9:50 AM, Blogger morganovich said...

"Why single out inside information?"

because it is different.

it's definitive information and can be used by insiders in self serving fashion.

it reduces the whole investing equation to "call the CFO, hear the numbers".

there is no way to compete with it.

this is not true of an algorithm, talent, computers etc.

that is competition, insider trading is nepotism.

nepotism is NEVER a good foundation for a market or an economy.

 
At 5/27/2011 9:59 AM, Blogger morganovich said...

"If you could legally buy the information off the insider, would you? I think you would. I would. information is valuable. You would rather make a trading decision after factoring in all information, wouldn't you?"

i think you are confusing two idea here, system theory and tactical decision making.

if buying insider information were legal, we would all need to by it. it would create a terrible hobbsian dilemma. if i thought you were going to buy it, then i would have to to compete.

however, this is devastating from a system perspective.

we all buy it, so it's value is very limited. it also shifts all the returns to the insiders.

such a system leaves us less competitive than before. we all pay for the same thing. the day we get it, the stock will move violently. the insiders get rich, and the market is a nepotistic farce.

this makes investment less attractive, will drive down P/E's and make capital more expensive for companies therefore disrupting the whole economy.

the whole point is that if it were legal, we would all have to buy it, but, systemically, the whole investor class would be worse off. (and quite possibly the whole economy as well)

it's a classic prisoner's dilemma.

we wind up at the low equilibrium by virtue of the system.

that is why the deign of the system and its rules are so important.

not all sets of market rules lead to desirable outcomes.

(i studied a lot of game theory)

the design of the rights structure matters.

giving the insiders the right to sell the numbers for the q makes investors worse off and the market less free. we all wait in line for the same data. we get it, and the stock does what it would have done on the reporting date. it's the same move, but earlier and we have to pay for it.

the incentive to get the number earlier than your peers will be massive. you pay more to go to the front of the line. then i outbid you. then you me. etc. pretty soon, we get the data the second it is available and the bidding process has shifted our returns to the CFO.

why is that in any way desirable?

 
At 5/27/2011 10:04 AM, Blogger Methinks said...

it reduces the whole investing equation to "call the CFO, hear the numbers".

there is no way to compete with it.


What happens to the profit potential of that trade when everyone and their dog is calling the CFO and the insiders in the company who don't need to call the CFO are also trading on that information?

nepotism is NEVER a good foundation for a market or an economy.

Decriminalizing insider trading would not make it a foundation of the securities market. Let's not start exaggerating here.

Nepotism is a factor in every market. the labour market, for example, is rife with it. Nepotism is also not the only advantage. If you trade for a large company, you can do things that you can't do if you trade for a small one. That gives you a huge advantage. So?

 
At 5/27/2011 10:17 AM, Blogger morganovich said...

"competitive markets are not characterized by excess returns"

only as an average.

there are always people in competitive markets that make outsized returns.

professional football is an extremely competitive market. but some teams always outperform.

what if they could buy the next play the other team was going to run? that would make it more efficient in terms of information and defense allocation.

but is it fair?

would it make the league better?

no. it would bankrupt teams. you'd have to buy plays. the price would eat your whole profit.

the "efficiency" of the system would eat all the profit and redistribute it to a select few based not on merit but position.

it's not a better system.

you can spend all you want on shoes and trainers and offensive coordinators, but definitive information is different. it's not just a competitive arms race then, it's a hobbsian dilemma based on nepotism.

 
At 5/27/2011 10:24 AM, Blogger morganovich said...

"What happens to the profit potential of that trade when everyone and their dog is calling the CFO and the insiders in the company who don't need to call the CFO are also trading on that information? "

this was my point exactly. it costs lots of investor money to make the market no more efficient, it just moves the effective report date to the day the numbers are tabulated as opposed to reported.

it reduces investment returns for no real purpose while making the market incredibly nepotistic.

what's the rationale for doing that?

"Decriminalizing insider trading would not make it a foundation of the securities market"

i completely disagree. it absolutely would. imagine trying to trade in a market where others got to see press releases a week before you.

wanna come play poker when i can look at your cards?

of course not.

you'd have to pay too.

the whole near term market would be about fighting for a place in the "insider information line".

long term you might be able to trade otherwise, but tactically, the market would be driven entirely by nepotistic access to information.

 
At 5/27/2011 10:54 AM, Blogger Methinks said...

if buying insider information were legal, we would all need to by it. it would create a terrible hobbsian dilemma. if i thought you were going to buy it, then i would have to to compete.

If I thought you had faster computers, I'd have to buy even faster ones in order to compete.

Similarly, there are investor news letters which cause huge market moves in low to medium liquidity stocks. To get the ratings change first, you have to buy the news letter.

But, I think maybe you're not thinking this all the way through, Morganovich.

Here's just one realistic example of what will actually happen:

The company misses estimates by a lot. You call the CFO (as do a million other hedge funds). He tells only his buddies. So, five of you know. That information is useless to you until you trade on it. You all trade on it, revealing the information to the market.

Insiders usually go to the options markets. But, since not everyone who may be reading our exchange is all that familiar with derivatives, let's pretend you and five of the CFO's best friends show up in the equity market.

Suddenly, there are a bunch of sellers dying to sell. I'm a market maker in the security in question. Seeing this new activity, I know that the information (whatever it is) is big and I know in which direction it'll take the stock (you're all selling). In placing your orders you've just informed the entire market (the great thing about electronic markets is that not just MM's see this information any more). The information is out. Through your nepotism, you've just prevented Grandma Jones from buying at a price that doesn't reflect the new information.

The rest is obvious. I sharply lower my bid, I probably plonk a huge sell order in front of yours to try to take advantage of whatever it is you know. I'll compete with you until you back off. When you back off, I know the value of your information is fully reflected. We're probably at fair value.

In reality, in all but the most illiquid securities, this would happen almost instantaneously. Your information would be revealed to the entire market in one fell swoop and competition not only from your fellow nepotists but from other traders (with a brain - which is a large enough number to be significant) to whom you revealed information by trading on it have reduced your profits significantly. And, like I said, the cat is out of the bag faster.

I understand your moral aversion to nepotism - whether in securities markets or labour markets, it's unpleasant. But, that's not an issue for the SEC. It's a moral dilemma for the firm (as is possible theft of information), but it's not a criminal issue for the SEC to deal with. It neither manipulates nor hurts the market. It does not make markets less fair and disorderly. It is far more fair to reveal the information to Grandma Jones when it first becomes available.

 
At 5/27/2011 11:02 AM, Blogger Methinks said...

this was my point exactly. it costs lots of investor money to make the market no more efficient, it just moves the effective report date to the day the numbers are tabulated as opposed to reported.

Exactly. The market is more information efficient. Fewer trading decisions are made on stale information.

I think I addressed the rest in the post above.

Incidentally, the scenario I describe has happens all the time. I can't tell you how many times in my career this scenario has played out (again - the options market is the place to go for insider traders). Insiders do trade and their profits are unusually large because they don't have competition from other insiders because insider trading was criminalized in the 1960's.
This is a fairly new law which costs an arm and a leg to maintain and doesn't do a thing to better the market.

Just play around with it in your head some more, Morganovich.

 
At 5/27/2011 11:05 AM, Blogger Methinks said...

Morganovich,

I wrote a post to which I just referred and I notice it's gone. unfortunately, it happened to have addressed a lot of what you object to in the new posts from you.

I can't rewrite it at this moment. Please check for it later.

 
At 5/27/2011 11:14 AM, Blogger morganovich said...

"Exactly. The market is more information efficient. Fewer trading decisions are made on stale information."

but the market now has a huge drag on it: paying for info that used to be free.

that is not costless.

i think you are missing the problem here:

costs go way up, but efficiency doe snot really improve, only the effective reporting date.

"costs an arm and a leg"?

no.

almost nothing is spent on it.

 
At 5/27/2011 1:48 PM, Blogger Methinks said...

no.

almost nothing is spent on it.


Absolutely untrue. Do you have any idea what the cost of compliance with Reg FD and insider trading "preventions" is? Just an example: Every broker dealer must have a compliance officer collect and the private accounts of every employee (not just the employee's but the accounts of his wife and children and any relative living with him) and check every trade to make sure there's no insider trading. Do you have any idea the drag this causes as productive employees' time is wasted in complying with this idiocy? And that's just one of the insider trading compliance idiocies. There are similar SEC hoops public companies have to jump through to comply with similar requirements (although, I'm not intimately familiar with the specific requirements).

And then there are the people at FINRA who make sure you're complying. You don't have to do this because you're not a hedge fund. The drag on the market is enormous.

It's not enough just to not trade on inside information.

 
At 5/27/2011 2:50 PM, Blogger morganovich said...

reg FD i grant you.

that was a terrible idea and has been an abysmal failure. extending the regulatory boundary too far is highly damaging as well.

that said, it's not the reg FD aspect of sarbox that has cost all the money.

filing the occasional 8k is not that big a deal.

i think you are confusing it with the other ruinous accounting and regulatory changes that came at the same time.

i sit on several boards. i've heard a ton about sarbox costs, but not reg fd.

compliance officers go far beyond insider trading. legalizing that would not do away with them, so the savings you purport seem illusory to me.

 
At 5/27/2011 2:50 PM, Blogger Methinks said...

but the market now has a huge drag on it: paying for info that used to be free.

that is not costless.


You did not just say that! Since when has information been free?

You are forgetting entirely the cost of NOT having the information.

The price of the inside information is the difference between the fair value price (of the security) computed using stale information and the fair value price computed using the new information.

A simple example: If the bad quarter is computed Monday and the press release goes out on Friday, everyone who buys that week is overpaying. The fair value of the stock drops on Monday (the earliest date the info is known to anyone), but the market is not informed until Friday. Would you rather overpay by the full value of the amount by which the stock is over priced or pay a small fraction of it because an insider released it?

Here’s what I wrote in the post that died.

Morganovich:it reduces the whole investing equation to "call the CFO, hear the numbers".

there is no way to compete with it.

You obviously aren’t naive enough to think people don’t ever trade on inside information because it’s illegal. We see inside information revealed in trades often enough. It happens.

Not only do you call the CFO, but so do all your other hedge fund competitors. The CFO is good buddies with only five of you and he gives only you guys the information that the company missed its earning and badly. All of you know that you’re not the only ones with the info. You need to act on it ASAP or the other’s will and the new information will be priced in.

Incidentally, all five of you will show up in the options market to buy puts. This is we see the vast majority of insiders. But, I’ve learned over the years that other people read our posts and some of them may not be as familiar with derivatives. So, in case anyone else is following our conversation, let’s pretend all of you go to the stock market to act on your inside information.

 
At 5/27/2011 2:51 PM, Blogger Methinks said...

All five of you show up with your sell orders. This unusual activity immediately alerts everyone trading that stock that something is going on. We don’t know what the information is, but we do know that you’re anxious to trade on it (size is large relative to normal) and we know the direction the stock is going to go (the large size is offered). As an MM, I’m obligated to quote, so I can’t cancel my market. Every retail trader and hedge fund can just cancel his bid. I’m forced to trade. What do I do?

I immediately drop my bid and reduce the size of my bid. If you hit it out, I drop it further and by a larger percentage. If you’re still hitting out bids, I drop it further (I know my fair value calc is stale now for sure in light of this order flow) and I join your offer, stepping ahead of you. If you continue to step in front of me to sell, I know that we’re not at the new fair value yet. When you stop competing with my offer and stop hitting out bids, I know we’re at the new fair value. The entire time, I have no idea what information you had.

In reality, this would happen within seconds or a couple of minutes (depends on how liquid the stock is). Also in reality, electronic markets make it possible for everyone to see your activity.

The stock is repriced almost instantly. Nobody will be overpaying for it. You and your hedge fund buddies, in an effort to seek to profit on your information advantage just released the information.

Since you were forced to keep stepping down, your profits were not the difference between the stale info price and the new info price. It was something in between and because you’re not trading with a bunch of dead-behind-the-eyes fools (they’re usually blown out of the market by their own stupidity quickly), you were not able to capture much profit on the information advantage. Not as much, btw, as you would have if insider trading were still illegal and your four competitors weren’t there.

It’s also entirely possible to not profit at all if the bid drops enough when your orders hit the market such that hitting it out would mean that there’s no edge in your trade anymore (the bid is at the new fair value price). And, cutting up your order won’t work either. The above scenario would just happen over a longer period of time.

I reiterate that no information is costless and the cost of insider information is lower than the benefit. Your nepotism doesn’t get you very far. It may be unpleasant - whether it happens in the labour market or any other market, but it’s not an issue for the SEC to deal with. It’s an issue for the company to address.

The SEC’s concern is a fair and orderly market. Forcing people to trade on stale information is unfair and insiders do not not make the market more disorderly while they do make it more information efficient and fair.

If Grandma Jones were going to buy the stock in question on Tuesday, you’ve just prevented her from overpaying for it by revealing information on Monday.

Grandma Jones will be especially happy if the information you happened to reveal is fraud because the company the company’s time line for revealing that information was NEVER

 
At 5/27/2011 2:58 PM, Blogger Methinks said...

As, I said, I'm most qualified to talk about the drag on broker dealers. You know, like your prime broker.

compliance officers go far beyond insider trading. legalizing that would not do away with them, so the savings you purport seem illusory to me.

I don't understand where I was unclear. Assume I hired just enough compliance officers to perform the current compliance work. The SEC turns us into insider trading police (which is what it's done). I now have to hire another compliance officer.

Come on, Morganovich! I would have thought thinking incrementally came naturally to you.

 
At 5/27/2011 2:59 PM, Blogger Methinks said...

only as an average.

there are always people in competitive markets that make outsized returns.


I have no idea why you think this is relevant.

 
At 5/27/2011 3:25 PM, Blogger Methinks said...

Just to clarify why I have no idea why that's relevant:

The probability distribution for trading on inside information includes both excess returns and losses - just like the probability distribution for interest rates includes negative and super high interest rates.

That such an outcome exists in the probability distribution is irrelevant. What's relevant is expectancy. In a competitive market, the expectancy is no excess return.

You're a man intimately familiar with business decisions. If someone came to you looking for an investment and said "I'm looking to enter a very a competitive market where profit margins are 1%. I will be offering a product that is in no way different from the product everyone else is offering and my operating costs are exactly the same. We are not at all differentiated from the rest of our competitors in any way. BUT! We expect to have a profit margin of 8%". How fast will you escort them out of your office and how much will you laugh once they're gone?

Do you trade on a hope and a prayer or on expectancy? I trade on expectancy and I think you do to.

 

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