August 12, 2014

Study casts new light on insider trading

by Christi Mathis

CARBONDALE, Ill. -- New research by a team that includes a finance expert at Southern Illinois University Carbondale suggests that some illegal insider trading is the result of information leaks from state and federal regulatory agencies. 

Wanli Zhao, associate professor of finance, partnered with David M. Reeb, the Mr. and Mrs. Lin Jo Yan Professor in Banking and Finance at the National University of Singapore Business School, and Yuzhao Zhang, assistant professor at the Rutgers University Business School, for the study into insider trading involving supervised industries. 

Their findings are being published under the title “Insider Trading in Supervised Industries” in the August 2014 edition of the prestigious “Journal of Law and Economics.” 

“Our findings are somewhat controversial in that we’re saying the presumed protectors of the shareholders and general public interests appear to be using their positions to their advantage,” Zhao said.  “The evidence shows it is happening.  There is more insider trading within regulated firms than within unregulated firms.  There is very, very strong indirect evidence that this is due to people involved in the regulatory agencies.” 

Here’s an example of how it might work.    A pharmaceutical firm has a new drug awaiting Food and Drug Administration approval, and presumably no one inside or outside of the company knows for sure what the FDA verdict will be. But, in the couple of days before the decision is released, there is an obvious spike in trading of the company’s stock.   It is apparent someone is aware of what the decision will be, Zhao said.  

By law, companies must disclose pertinent information to regulators.  When regulators combine that pertinent information with information known only to them, it allows them or people they share that information with to have distinct stock market decision advantages, he said.  

Another example involves the banking industry.  A bank must report financial information to the Federal Reserve each quarter and that information is made public a few days later.  Zhao said they’ve discovered that frequently, a higher amount of trading involving bank stock takes place during that few day period after information is provided to regulators but before it becomes publicly known. 

“It’s all indirect evidence.  We don’t know the identity of the traders or the mechanisms by which they are sharing the information – whether it’s pillow talk, social media or simply telling other people such as hedge fund managers, but there is plenty of evidence it is happening,” Zhao said.  

The evidence takes several different forms.  In some instances, a higher than usual cumulative abnormal return, or CAR, is a possible indicator.  Essentially this is a noticeable increase or decrease in buying or selling of a specific stock just prior to public disclosure of pertinent information or decisions, Zhao said.  If there is a substantial upswing or downswing in trading during that short window before a public announcement, it may be because of insider information. 

Another indicator is a sharp increase in short sales, where people actually sell stocks they don’t yet own.  They negotiate a price to sell a stock to someone and lock in a deal, anticipating the stock price will plummet based on private information they possess. They then purchase the stock at the lower market price and profit from the price differential they had previously negotiated. 

“There are other reasons for short sales, but if there is a spike in short sales, particularly right before bad news, it is a good indicator that insider trading may be involved, especially after controlling for other factors,” Zhao said. 

A third possible indicator involves Probability of Informed Trading, or PIN.  Zhao said this measure captures the information contained in the pattern of informed and uninformed trades on a daily basis.  

“All three indicators individually don’t necessarily prove insider trading. But in tandem, it is a strong and confident confirmation.  If all three are in agreement, it is pretty clear verification of insider trading,” Zhao said.  “Our research does not reveal exactly how the information is being passed nor why, whether it is inadvertently, purposely, or because regulators feel they are entitled to profit since they may work in lower-paid positions.” 

The team spent nearly two years conducting research, studying a variety of industries overseen by regulatory agencies including banking, insurance companies, pharmaceutical businesses, and publicly traded utilities.   The pertinent regulators include the Federal Reserve, the Office of the Controller of the Currency, the Federal Deposit Insurance Corporation, the FDA and state-level public service/utility commissions and insurance company regulatory agencies and commissions. 

The number of firms involved in the study varied depending upon the measures and tests applied.  For instance, for the cumulative abnormal return examination, the researchers studied 1,930 regulated firms and 4,638 non-regulated firms while the short sales test covered 630 regulated and 1,228 non-regulated firms, due to data availability.   The researchers studied 293 insurance companies, 379 utility companies, 80 pharmaceutical companies and more than a dozen publicly traded commercial banks, Zhao said.