Turning financial markets inside out: how insider ...

Int. J. Critical Accounting, Vol. 2, No. 4, 2010

Turning financial markets inside out: how insider trading regulation really works Ulrika Sjödin* and Thomas Bay School of Business, Stockholm University, Roslagsvägen 101, 106 91 Stockholm, Sweden Fax: +46 (0)705-833-189 E-mail: [email protected] E-mail: [email protected] *Corresponding author

Elton G. McGoun Bucknell University, 701 Moore Avenue, Lewisburg, PA 17837, USA E-mail: [email protected] Abstract: Insider trading regulation produces excess speculation and stimulates deceptive stock exchange trading – the very things that it is supposed to eliminate. In Sweden, this was part of a deliberate political agenda to make financial markets livelier and more exciting, almost as if they were games. Now, the so-called ‘outsiders’ (the public) are in fact confined inside the game, while the ‘insiders’ (the market professionals) remain outside the game controlling the action. Keywords: insider; outsider; insider trading; insider regulation; excess; speculation; game. Reference to this paper should be made as follows: Sjödin, U., Bay, T. and McGoun, E.G. (2010) ‘Turning financial markets inside out: how insider trading regulation really works’, Int. J. Critical Accounting, Vol. 2, No. 4, pp.419–436. Biographical notes: Ulrika Sjödin is a Senior Lecturer at Stockholm University School of Business. Her dissertation, ‘Insiders’ outside/outsiders’ inside – rethinking the insider regulation’ won the 2006 award for best Swedish dissertation within the field of business administration. She is currently studying the work being done on creating new and more flexible ways of regulating the financial markets through increased transparency and access to real time events. The study is part of the research project critical finance studies. Thomas Bay is a Senior Lecturer at Stockholm University School of Business. He is currently developing a new research project – critical finance studies – using philosophy and art to forge new conceptual tools making it possible to resist the otherworldly financial metaphysicians of this world; to defunctionalise their ideonomic division apparatuses; and ultimately, to provide opportunities for transforming one’s life in relation to transcendent forces in the course of producing new ways of thinking, feeling and existing. Copyright © 2010 Inderscience Enterprises Ltd.

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U. Sjödin et al. Elton G. McGoun is a William H. Dunkak Professor of Finance at Bucknell University, a position which he has managed to attain despite being unable to execute or interpret an augmented Dickey-Fuller statistical test. This may or may not be related to his living across the road from a corn field and driving a 16-year-old pick-up truck.

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Introduction

Few would disagree that financial markets ought to be both efficient and fair. In an efficient market, the prices of securities reflect all available information and accurately represent the values of the securities. In a fair market, no group of investors has a systematic advantage over any other group of investors. It is not so easy, however, for a financial market to be both efficient and fair. Securities prices respond to the announcement of new information pertinent to their valuation, and as a consequence of their positions, some investors (insiders) have systematically greater access to information that will affect prices than other investors (outsiders). Insiders are therefore in a position to profit at the expense of outsiders. They can buy (sell) securities prior to the public announcement of their new positive (negative) information and subsequently sell (buy) the securities at a profit after the prices have risen (fallen). Today we believe that intervention is necessary to maintain markets that are both fair and efficient. If insiders were permitted to take advantage of their informational advantages and financial markets were unfair, there could be severe effects throughout the economy. Outsiders could panic and flee the markets, which may break down and cripple the real markets for goods, services, property and labour. This would lead to a less efficient economy. Thus, to achieve both efficiency and fairness, it is necessary to ensure that insiders release their new information (realising efficiency) without exploiting outsiders (realising fairness). At least this is how the government regulators who are responsible for ensuring that such a collapse does not occur see it. Their response is to impose regulations on insider trading to preserve the integrity of financial markets necessary to achieving economic stability and growth. Research into insider trading has traditionally reflected a dispute between legal and economic scholars: the former emphasising a fair and regulated market and the latter an efficient and unregulated market (Leland, 1992; Hu and Noe, 1997). This research debate has created the image that insider trading regulation is essentially the outcome of a ‘tug-of-war between efficiency and fairness, in which relative strength continually shifts from side to side’ [Shefrin and Statman, (1993), p.21]. In this paper, we examine the case of financial markets in Sweden and propose an alternative interpretation of insider trading regulation to that of both the government regulators and the traditional legal and economic financial market researchers. Although it may appear to be yet another one among many other laws and regulations required for the proper (efficient and fair) functioning of financial markets, insider trading regulation is quite different and these differences suggest that there is more to this regulation than meets the eye. In Sweden, it preceded evidence of insider trading – there were no confirmations that markets were unfair before insider trading was regulated and made into a criminal act. It even largely preceded public concern with insider trading – people did not even think that markets were unfair before insider trading was regulated. This is in contrast to most laws

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and regulations, which (at least in theory) are reactive, that is, passed or issued in response to undesirable activities in order to prevent their recurrence. Moreover, insider trading is not a normal crime with an identifiable victim and it cannot be detected and proven by normal criminal investigative and judicial procedures. Curiously, insider trading is not an issue in markets for goods, services, property or labour; it is only an issue in financial markets. One might say that insider trading is the exemplary postmodern crime: a perfect simulacrum – the image of a crime without there being a crime (Baudrillard, 2001/1998). It does not matter whether there is insider trading or not; it only matters whether outsiders believe that there is. The consequences if a financial market is thought to be unfair are no different than if it is in fact unfair. It does not matter whether investigators detect insider trading or not; it only matters that they look as if they are able to and are trying to. If it is only necessary that financial markets are thought to be fair, it is only necessary that government regulators appear to be concerned with achieving fairness. For example, an official document of the Swedish Department of Finance explains that: “According to current legislation, courts shall not impose liability for breaking the insider trading law in cases which can be assumed to be of no importance with respect to the public’s confidence, or else is minor.” [Ds, (2000), p.4]1

In other words, the courts will not take action against insider trading unless it might affect the public’s confidence. The goal is that investors do not ‘refrain from trading, i.e., reduce the participation rate’ [Niemeyer, (2001), p.21], so ‘fair’ financial markets have more to do with our perception of fairness than with actual fairness (Moore, 1990; Bainbridge, 2001). And for this reason, it does not matter whether prosecutors convict and punish inside traders or not; it only matters that they charge them every once in a while. Producing an image of guilty criminals is as effective at creating an image of fairness as is prosecuting authentically guilty criminals. With regard to insider trading in Sweden, a crime has been simultaneously created and prevented by passing laws against it, and confidence in financial markets has been strengthened by simultaneously creating a threat and guarding against it.2 As unusual and ‘unreal’ as insider trading regulation may be, however, it can still have the intended ‘real’ consequences of increasing confidence in the integrity of financial markets and stimulating trading. Financial markets become more liquid and less risky as a result of more accurate prices. They become more effective at transferring capital from those who have it to those who can put it to the best use; they become more effective at transferring risk from those who are not willing to bear it to those who are; the country realises economic stability and growth. The conventional story would end here. Other ‘real’ consequences of the insider trading regulation, though, are that financial markets are riskier as a result of more trading and thus more volatile prices. As trading is itself a source of new information, more trading means more new information and more price changes, albeit price changes having no necessary bearing on value, assuming that there really is such a thing independent of price. As a result of the felicitous rule prohibiting insider trading, financial markets have become a more exciting and more popular game effectively indistinguishable from gambling. More trading generates more commissions on trading and more demand for assorted information services (Bainbridge, 2000). More volatile prices create more speculative opportunities, that is, more opportunities to benefit from

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price changes. More volatile prices and more trading create more manipulative trading opportunities and make it more difficult to detect manipulation (Niemeyer, 2001). The market makers who are in the best position to benefit from these livelier markets do not have to worry anymore about being on the opposite side of a trade from a better-informed insider. Thus, they receive windfall profits as a result of a regulation intended to eliminate the possibility of anyone receiving unfair windfall profits (Bainbridge, 2001). In effect, the roles of insiders and outsiders have been reversed. Consider René Magritte’s painting ‘The month of the grape harvest’ (Figure 1). If this represents a financial market, who are you? Are you a privileged market professional at the centre of the action looking out at the mass of outsiders who wish they were where you are? This is the traditional view of financial markets. Or are you an outsider confined inside the game looking out at the market professionals who are taking advantage of you? This is how we suggest it is. Figure 1

The month of the grape harvest (see online version for colours)

The structure of the paper follows this outline of the abbreviated argument presented in this introduction. Section 2 explains what it is that is different about insider trading regulation and concludes that its purpose is to stimulate trading, or more accurately speculation, on financial markets. Section 3 examines the consequences of increased speculation more closely and Section 4 describes who benefits from these livelier markets created by insider trading regulation. We conclude in Section 5 with a discussion of


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insider trading regulation as the consequence of a political agenda to privilege financial market professionals.

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The peculiarities of insider trading regulation

Manne (1966) provided the classic argument for the value of unrestricted insider trading. His point was that insider trading, due to its high information content, increases market efficiency. It is a cheap way to attain ‘correct’ securities prices and also to compensate entrepreneurs for their efforts. This argument is in line with the classic ‘perfect information’ ideal (Stiglitz, 1993). An efficient financial market is a market where all available information is rapidly reflected in securities prices (Fama, 1970). A price which reflects all available information is considered to be ‘accurate’, something which is believed to reduce uncertainty and therefore decrease the risks of dealing in securities. This is seen as efficient. It should decrease the risk premia demanded by investors to take on the risk of making an investment, thereby decreasing the company’s cost of capital. Thus, the quicker new information reaches the market, the more efficient that market is. Unhampered insider trading supposedly communicates new information quicker than otherwise would be the case, which decreases the risks inherent in stock trading. Outside investors are supposed to be able to profit from this information too by following the insiders’ example (Jaffe, 1974; Carlton and Fishel, 1983; Martin and Peterson, 1991; Leland, 1992; Shefrin and Statman, 1993; Hu and Noe, 1997; Rozeff and Zaman, 1988; Ronen, 2000; Bainbridge, 2001). But if on the other hand insider trading scares away market participants, this would reduce the market liquidity and market efficiency (Dye, 1984; Manove, 1989; Hu and Noe, 1997). Unfortunately, there is no way to know the extent to which market participation would be reduced, but even market professionals (professional money managers and market makers) are only able to take large positions because they know there are not better-informed investors on the other sides of their trades. With fewer market participants, both outside investors and market professionals not always on the ‘inside’, markets would be far less liquid and intermediaries’ spreads far wider. Therefore in most mature financial markets, it is illegal for anyone to buy or sell financial securities on the basis of information that has not yet been made public, that is, ‘inside information’. This is supposed to ensure everyone’s confidence that in financial markets trading is fair and everyone has equal opportunities to profit (Löfmarck, 1988; Bainbridge, 2001; Niemeyer, 2001). Illegal insider trading is broadly seen as a major threat to the integrity of the financial markets. Unlike other illegal activities, however, ‘insider trading remains, at least among economists and legal scholars, one of the most controversial economic transactions’ [Hu and Noe, (1997), p.34]. One controversy is that the basis for the criminalisation of insider trading appears to be the mere existence of asymmetric information, that is, that someone knows something relevant to price formation that someone else does not. A rule against asymmetric information would not appear especially odd in a lottery or in a casino, but in a competitive economic setting it does not make sense. ‘All sorts of economic agents profit from informational advantage in a market economy, and such exploitation is not in general viewed as unethical. Why then is exploiting an informational advantage in securities trade unethical?’ [Hu and Noe, (1997), p.39].

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Because asymmetric information is everywhere in every market, there is no crime as hard to prosecute as insider trading. In effect, the authorities must prove what was inside the defendant’s head at the time of the trade: that the person knew the inside information and traded because of it. Since it ‘is very hard to prove peoples’ thoughts,’ as a member of the Swedish Economic Crimes Bureau (EBM) put it in an interview, it is very difficult to get the sort of concrete evidence of insider trading demanded by the law. The insider regulation has been severely criticised because of its inefficiency (Ma and Sun, 1998; Ronen, 2000; Bainbridge, 2001; Wesser, 2001; Bhattacharya and Daouk, 2002). Another controversy is insider trading’s obscure and seemingly ‘non-existent’ connection to traditional securities law (Bainbridge, 2001; Löfmarck, 1988). Although insider trading is perceived as extremely ‘unfair’ and ‘immoral’, it can be difficult to see real victims, and there are no individual or organisational plaintiffs to take a matter to court (Manne, 1966; Bainbridge, 2001; Ronen, 2000). US common law, for example, requires that securities fraud involve a breach of trust in a personal fiduciary relation (Bainbridge, 2001) and usually demands active manipulation in order to impose liability. Someone must have intended to deceive an identifiable someone else and acquired something valuable from them as a result of that deception. Because insider trading is a crime conducted on an impersonal and usually anonymous market, no one can sue someone personally for trading on private information and receive compensation.3 As we have noted, many scholars have gone so far as to question whether insider trading is harmful, let alone deserving prosecution and even argued that it is valuable (Manne, 1966; Carlton and Fishel, 1983; Givonly and Palmon, 1985; Rundfelt, 1989; Hu and Noe, 1997; Ma and Sun, 1998; Ronen, 2000). Although the absence of plaintiffs is a strong argument against insider regulation, an ‘absence of plaintiffs’ is not the same as a ‘lack of victims’ (Brudney, 1962). That there are no individual plaintiffs does not mean that there are no harmful effects of insider trading. Someone can do harm without hurting anyone specific. Corporate scandals, for example, are costly for society as a whole. ‘Because economic crimes generate distrust and lower the general morale, they attack the fundamental principles of society’, ‘this may lead to the disorganisation and dissolution of the norms of society’ [Emanuelsson Korsell in SOU, (2003), Vol. 10, p.16]4. The economic damage from economic crimes is ‘ten to 35 times larger than in the case of conventional crimes’ (Ibid., p.15). ‘This is different from traditional criminality, which primarily hits individuals and which therefore affects the foundation of society to a much lesser extent than economic crimes’ (Ibid., p.16). Many scholars maintain that the regulation is solely motivated by moral considerations (Keenan, 2000; Smith and Snoyenbos, 2000; Moore, 1990; Salbu, 1995; Werhane, 1991; Easterbrook, 1985; Brudney, 1979). All told, insider regulation is an entirely new kind of criminalisation; it is literally ‘a new land of the law’ (Bainbridge, 2001); ‘a strange bird in the nest’ (Leijonhufvud, 2003). The origins of insider trading regulation in Sweden set it apart from other laws in other ways. We usually take it for granted that behaviour is not – and even should not – be prohibited until it happens and causes undesirable consequences. The powerful forces of law are assumed to only repress and discipline bad behaviour that exists before the laws of society and the workings of the authoritative power (Foucault, 1990/1976). But in Sweden, it was the law that came first and the illegal behaviour second. The motive behind the criminalisation of insider trading in Sweden is stated in an Official Swedish Governmental investigation:


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“There are indications of insider speculation. However, as insider trading has not yet been sanctioned there is no evidence of its actual existence. The investigation has nevertheless found that already the suspicion of insider speculation disturbs the trust in the financial markets in such a serious way that a sanction should exist.” [SOU, (1984), Vol. 2, p.12, italics added]

Trust as such is so important that in the USA, ‘[s]anctions are imposed whether or not the insider was in fact influenced in conducting corporate affairs by the possibility of obtaining trading profits for himself, and whether or not the corporation and its security holders were in fact injured’ [Brudney, (1962), p.3, italics added]. The perception and suspicion are more important than the actual circumstances. Sanctions against insider trading have been imposed regardless of the underlying reality, that is, regardless of the actual existence of either insider trading or injured investors. This was done in order to create lively financial markets with a high ‘participation rate’ (Niemeyer, 2001; De Goede, 2005). Despite the fact that today’s lively and liquid financial markets have thus been created by the rules and regulations of the state and the actions of professional market actors, the tone of the discussions in the Swedish Official Governmental investigations (SOUs)5, in other governmental publications (FIs)6, and in other legal and economic literature is still that insider trading legislation is a mere response to a ‘natural’ increase of public interest in stock exchange trading. The market is treated as a natural institution, the functioning of which is independent of human agency. As it operates, some market participants unfortunately engage in activities detrimental to others, and some authority is required to intervene to identify, isolate and punish the offenders. Löfmarck’s (1988) book Insider Trading och Svindleri was written to provide the Swedish authorities with suggestions/advice how to design Swedish insider trading regulation, although it does not seriously examined the political motives and socio-economic context. She sees the regulation originating from the need for ‘fair play’ for the general public, which was taking an increased interest in stock exchange trading. “The political interest to obstruct insider trading is clearly linked to the existence or non-existence of groups worthy of protection on the market, something which has changed dramatically in Sweden – and coincides with the lawmaker’s interest in insider trading… West Germany represents a different line of thought; their strategy has so far focused on self-regulation as an adequate method against insider trading. The West German attitude must be seen in relation to the conditions on their stock market: there are not a lot of investments by small investors and other non-professional investors.” [Löfmarck, (1988), p.5]

Similarly, Frii (1998) links the relatively early US insider trading prohibition to the large number of private investors in the US stock markets and the relatively late German ban to the absence of many non-professional investors there. In other words, insider trading regulation is essentially a response to the anticipated needs of an imagined cadre of naïve investors and not to redress wrongs seen to have been inflicted on anyone. The law usually views economic problems as disputes between two identifiable living human beings (Manne, 1966; Löfmarck, 1988), and accordingly the ‘interest in need of protection’ (the identity of the plaintiff) must be specified (Löfmarck, 1988). The efficiency of a regulation at accomplishing the purpose for which it was issued does depend on the existence of plaintiffs’ interests to protect – on the existence of victims to identify. Prosecution of a crime towards ‘a diffuse public which is not entitled to

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compensation’ [Löfmarck, (1988), p.42] is necessarily a vague undertaking. However, the identification of the victims in the case of insider trading is not as important for the sake of the victims as it is for the sake of the precision of the prohibition. “After establishing that the ground for criminalisation is the public trust in the financial markets it is important to move on to try to specify the interests in need of protection… Which or who are the legal interests worthy of protection, who, more concretely, is put in danger by the insider trading? Against whom are such deeds directed? Such evaluations are necessary in order to shape rules that will hit the target ‘with precision’. But they can also contribute to making the motive behind the regulation clearer in a way that can better satisfy the demands of objectivity.” [Löfmarck, (1988), p.35]

In studies such as Löfmarck’s, laws and markets are treated as naturally given, while the human factor in their origin and creation is not taken into account or even mentioned at all. This is nothing remarkable – it is the ‘traditional juridical method’ (Votinius, 2004), the method of merely finding out how to fit legislation into existing law (Derrida, 1992). The focus of these studies is on how to design laws that hit their targets with precision. It is on the reactive or negative side of the law – on that which is restricted. The proactive, the positive side of the law concerning that which the law itself produces, is forgotten or neglected. Law does indeed often, but not always, arrive as a corrective response to preexisting conditions and the economic and juridical perspective ignores the productive creative power of its disciplining practices (Foucault, 1990/1976). Laws and economic regulations have just as much to do with a desire to create new behaviour, attitudes and values as they have to do with restricting already existing behaviour, attitudes and values. Thus, there is in all law a creative movement that goes beyond the obvious morality inherent in a fairness/unfairness distinction of the specific regulated behaviour (ibid). In the case of insider trading, it is ‘to encourage the market actors to behave in a responsible way’ as it was put in the Government letter to the Swedish Parliament (2002/03) ‘The State and the Financial Sector’. We know that along with the passage of insider trading regulations, several measures have been taken by the Swedish authorities to resuscitate and liven up the Swedish financial markets and we know that this has involved a change of norms (Jonsson, 2002). It is quite likely that the majority of the Swedish people, before the governmental campaigns did not even know how to trade on the stock exchange (Burk, 1988). They not only were unaware of the immorality of insider trading, but also were unaware of the existence of insider trading, the extent of which has never been determined. Insider trading regulation did not so much follow the rush of small investors from ‘nowhere’ into financial markets as it was part of an active campaigns on the government’s part over the past 40 years to attract such investors to the newly deregulated and internationalised financial markets. Thus, one can make a strong argument that the implicit purpose of insider trading regulation was to a transform values and create a new financial reality with enhanced speculation and risk-taking. The desire for ‘fair play’ that is supposed to have been responsible for insider trading regulation is perhaps more accurately a consequence of the inevitable human envy of those who are privileged (Manne, 1970; Löfmarck, 1988; Bainbridge, 2001). In this case, the privilege is information and the regulation eliminates that privilege, thereby eliminating the envy. It is very possible, however, that insider trading regulation is not so much a concession to some already existing envy as a creation of a new form of envy – envy of those who have ‘earned’ speculative wealth.


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The consequences of speculation

The positive externalities of financial markets are often emphasised in the Swedish official investigations (SOUs). Growth of financial markets is synonymous with growth in the well-being of all individual sectors of the economy, all individual companies and even all individual households. The chief insider trading prosecutor, for example, has said that financial markets are not the games they may often appear to be because of their socially essential role allocating capital, reducing risks and in general improving economic efficiency. The director of the Swedish Financial Supervising Authority (FI) claims that: “The services of the financial companies are necessary in order for other actors and companies in the economy to run their businesses in a rational way… From this perspective, financial production can be seen as part of the infrastructure of the economy, comparable to communication systems and to energy distribution. Safe and efficient functioning of financial production is therefore important not only to the people working in the financial business, but to all.” [Bonde in SOU, (2003), Vol. 22, p.23]

Market efficiency is the ‘flagship’ of finance theory (Miller, 1999) and an ‘efficient market’ is a market in which all available information is rapidly reflected in stock prices (Fama, 1970, 1991). As we discussed in the previous section, many have expressed the belief that there is indeed a societal value in the information content of insiders’ trade (Manne, 1966; Carlton and Fischel, 1983; Ma and Sun, 1998; Ronen, 2000). Insider trading makes securities prices more ‘accurate’ because insiders’ trades are likely to be based on better information and less speculative belief than outsiders’ trades. If insiders are allowed to trade freely, stock prices would become ‘correct’ sooner and at less cost than if the same information were to be disclosed via periodic official announcements such as quarterly reports. Within the Swedish government, some have seconded this belief that there is indeed societal value in the informational content of insiders’ trades. ‘Outlawing insider trading means that market prices will not adjust to information as quickly as they otherwise would’ [Niemeyer, (2001), p.23]. In short, insider trading reduces the risks faced by investors in general, because with it in the market influencing prices, there is less chance of trading at a ‘wrong’ price. ‘As a result, the efficiency of capital market increases. Because firms use securities prices in making investment and capital budgeting decisions, an increase in price efficiency will lead to higher levels of economic output’ [Hu and Noe, (1997), p.40]. In finance theory, risk is price volatility, the more volatile the stock price, the higher the risk of buying and holding that stock. The creation of new types of financial instruments is legitimised by their usefulness in reducing such risk or at least reallocating it from those who do not want to bear it to those who are willing to do so – for an appropriate fee of course. We might even say that financial markets are all about economic prudence, about (re)distributing preexisting resources and minimising preexisting risks. Risk is seen as something altogether negative and unwanted, something accepted only reluctantly. At the same time, we might also say that financial markets are legitimised by their stimulus to the creation of risk in the real economy, that is, enabling more risky projects to be undertaken than would be possible without them. To progress, an economy must venture out into the (risky) economic unknown and must have risk-taking and risk-takers and thus risk-creators in order to do so (Crump, 1874; Burk,

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1988; Abolafia, 1996). Financial markets can mobilise the resources of many investors, large and small, for companies to undertake quite bold and venturesome projects. We are better able to create such risks in the material economy because we are better able to spread those risks around via the financial economy. Today’s stock exchange trader is a speculator. ‘[As] a specialist in the taking of risk, and in assuming the risk of price fluctuations, he sets other dealers free to specialise in their own jobs, whether as producers or users of commodities, manufacturers, traders or savers’ [Morgan and Thomas, (1962), p.270]. Entrepreneurs are imagined to possess an extraordinary and invaluable ability to generate and exploit fantastic new technologies, a quality missing in ordinary risk-averse people who want to be employed by firms rather than create their own risky business ventures (Burk, 1988; Abolafia, 1996). Speculators are the ‘altruistic heroes’ for coping with the risk that is the unwanted by-product of this process. Despite the activity of speculation begin lauded and encouraged, it has its darker side. Speculating – buying and selling a stock within a relatively brief length of time – cannot be profitable when price fluctuations are small and infrequent. It is useless to speculate in stocks in which the fluctuations are small (Crump, 1874), so financial speculators gravitate towards markets ‘where a bull or a bear stands to make profits in a short period’ (Ibid., p.120). According to Keynes, this is the inevitable result of financial markets in which buying and selling (speculation) has become as important as buying and holding (investment), that is, a market in which liquidity and risk management is a dominant function. Such markets are ‘so to speak, a game of Snap, of Old Maid, of Musical Chairs – a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops’ [Keynes, (1964/1953), p.156]. The activity of financial trade/speculation is not as unambiguous as it is usually presented. ‘Financial organisations … such as hedge funds, have become a major tool of global integration, speculation and, in the last resort, financial instability’ [Castells, (2000/1996), p.105]. This means that the activity of financial trade/speculation has what is sometimes referred to as a ‘Janus face’. ‘Janus is a pivotal symbol of gate-keeping, whose major characteristic is not that he can see in opposite directions at the same time, but that he is able to merge seemingly contradictory categories into a meaningful whole’ [Olsson, (1991), p.13]. The contradiction or paradox here is that financial transactions that are seemingly legitimised as hedging strategies to minimise price risks also participate in creating the very same price instability (volatility) they were ostensibly meant to reduce (Crump, 1874; Bay, 1998). Financial trade/speculation both minimises and maximises the financial risks in one and the same move. This ‘dual character’ is indeed sometimes acknowledged in official Swedish investigations [see for example, SOU, (2003), FI, (2005), Vol. 6], but it is neither seen as important nor as a problem. It is recognised that the international trade in financial derivatives is a stability risk and that expanding financial markets ‘share characteristics of both stabilising and destabilising character’, but the destabilising character is downplayed in favour of the perceived benefit of its stabilising character. “[O]ne of those dualistic traits when it comes to stability risks is the explosive increase of derivative trades as compliments to or substitutes for other financial products. The total amount of derivate contracts was in 2002 128,000 billion dollars, or approximately four times the value of the total GNP of the whole world. This has often been seen as an example of a growing potential system


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risk. We should at the same time remember that derivatives as such are a powerful technique to reduce, transfer, and price risk and thereby if rightly used to promote stability.” [Bonde in SOU, (2003), p.32]

Unstable markets and their attendant risks are ‘a scarcely avoidable outcome of our having successfully organised ‘liquid’ investment markets’ [Keynes, (1964/1953), p.159]. ‘Risk operates not only by predicting the dangers of the future, but by, at once, prospecting its opportunities’ [Bay, (1998), p.163]. Financial players buy and sell risks; price movements are the attraction of financial markets, and risk is their ‘product’ (Bay, 1998). ‘Well functioning’ financial markets are therefore not markets that move only in response to the release of new information, as rational finance theory would have it. There is not that much going on that is meaningful ‘new information’. Illiquid financial markets with few price movements and risks would be nearly dead markets and dead markets are poor sites for speculation (Shiller, 1981; Thaler, 1999; Statman, 1999). A well-functioning market is therefore not one with stable prices, but one with a high participation rate, high liquidity and the frequent price movements that mean risk. By drawing more people into the financial markets, insider trading prohibitions make those markets more lively (more volatile), thereby creating more speculative opportunities for savvy players. While the ‘informed’ may no longer prey on the ‘uninformed’, the ‘skilled’ may now prey even more on the ‘unskilled’.

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The beneficiaries of insider trading regulation

The purpose of insider regulation is to achieve total informational parity among traders. In truth, such parity does not make for a very liquid market and at the extreme, it makes for a perfectly illiquid market. If everyone were to have the same information regarding a stock and the information were good (bad), no one who owned the stock would want to sell it (be able to sell it), and no one who did not own the stock would be able to buy it (want to buy it). There would be no trading. Total informational parity makes sense in Las Vegas, but it does not make sense on Wall Street. Were there total informational parity on Wall Street, it would become like Las Vegas. Buying stock would be very much like betting on a throw of the dice, a spin of the wheel, or a turn of the cards, because the release of information would be just like those throws, spins and turns. Prices would move suddenly and violently upward and downward in great leaps. According to a Swedish financial analyst in conversation with one of the authors, insider trading resulting in the measured trickling out of inside information into the market and thus into prices is not only desired by market participants but is also a necessary condition for the very existence of the stock market. One reason is that inside information (or what is thought to be inside information) is what market participants trade on; it is what keeps the market and capital moving; that which creates ‘added value’ (Hasselström, 2003; Grossman and Stiglitz 1980). Another reason is that it is essential that information not be released all at once; there must be a steady and stable price adjustment via insider information leakage. Stable prices and slow steady price adjustment/correction is what the classical economists throughout time have always pointed out as the purpose of and good side of (commodity) speculation – speculation as protection against sudden price movement caused by the whims of nature and bad harvest (Crump, 1874; Thomas, 1901; Keynes, 1964/1953; Guillet de Monthoux, 1992/1983).

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Thus, if no information slipped out slowly beforehand but all information were released to everyone at once, it would be too risky to take positions involving thousands or even millions of dollars. What if there was some sort of mistake? Large price movements mean too much volatility, too much instability. If the market were really to function in accordance with the apparent wishes of the legislators who passed insider trading regulation that nothing leak out before the official release of quarterly financial reports, the professionals who are managing other people’s money would, according to this analyst, not be able to take a position because there would be too much risk that they might wrong. This would also apply to the market makers who must quote prices at which they are willing to buy or sell. Without professional money managers and without market makers, there would be no market. Note here the introduction of a distinction between ‘insiders’ and ‘market professionals’. The former have valuable information as a result of their positions, but these positions need not be in financial markets. Any private information concerning economic or business matters might turn out to be valuable. Market professionals, whose livelihood is earned performing some financial market activity, might also be insiders, but they need not be. Ironically, the prohibition of insider trading in a practical sense protects market professionals more than anyone else. They might be insiders on some trades and outsiders on some others, but probably more often outsiders than insiders. There just is not that much valuable inside information in relation to the volume of trading. They do not have the choice to trade only when they know something that few if any other people know. Assuming the preceding argument is true, this is the group that should become extinct if the regulation really worked. Many have pointed out that insider trading might put market professionals out of business (Hu and Noe, 1997; Leland, 1992; Dye, 1984; Shin, 1996). If ordinary investors were able to discover valuable information by observing insiders publicly trading, and because of this stopped buying the advice of the less informed market professionals, the demand for the market professionals’ services would drop. Fishman and Hagerty (1992) suggest that the consequences of this would be less informative and less accurate stock prices and a less efficient stock market. This is not, however, what has happened. It is not so easy for outsiders to follow the actions of insiders. Not only is the market so ‘noisy’ as to make it difficult to figure out just who knows what and who is doing what, but it is also virtually impossible to know what is information and what is not. In all but the most obvious cases, it is impossible to know who is an insider and who is an outsider. Insider trading regulations have created imaginary classes of ‘criminal’ insiders and ‘victimised’ outsiders and then simultaneously eliminated them. In practice, the insider/outsider ‘drama’ with respect to asymmetric information is not the real issue. The function of insider trading regulation is primarily to protect the business of the third category, the market professionals, the professional group which evaluates corporations and creates and sustains the secondary markets. In other words, these people are the financial system as such. They are what we might call the ‘semi-insiders’ who are insiders in relation to the outsiders (the public), but outsiders in relation to the primary insiders; they are those whom ‘the truth of either (insiders/outsiders) separately or both together fails to capture, which is neither and both of the two’ [Caputo, (1997), p.84]. They are the players who are in-between, the market makers who manage the market activity. They are less informed than the primary corporate insiders, but they are still the relative insiders compared to the general public


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because they mingle with the corporate insiders and know who is trading, how much they are trading and even why they are trading. Corporate insiders meet with market professionals at analyst meetings and other get-togethers. The market professionals go to these meetings in order to collect information that adds value for themselves and their own customers [Hasselström, (2003), p.79]. Hasselström spent several months at English, US and Swedish financial broker houses, and she reports that traders and brokers spend a lot of time hunting for officially unknown facts, as this is the only way of gaining what they call ‘added value’ [Hasselström, (2003), p.69]. Really useful market knowledge is word-of-mouth from sources who ‘know,’ which means people who are the sources, or are very close to the sources, of relevant information [Hasselström, (2003), p.58]. ‘In fact, information too widely shared is not seen as adding value’ [Hasselström, (2003), p.93]. It is common knowledge that all market actors do not have access to the same information, and this is the main reason behind the activity of the market professionals. In practice equal access to information stifles market activity. What does this mean? In practice corporate insiders must operate outside what we might call the ‘fair’ market arena, as they indeed do have and quite likely are using their privileged information (Keown and Pinkerton, 1981; Meulbroek, 1992; Richardson and Venkatesh, 1995; Kaestner and Liu, 1996; Udpa, 1996; Wesser, 2001; Sandeberg, 2002). The same might be said for the semi-insiders. ‘There is a collective acceptance among financial markets actors of a certain amount of illegal and morally dubious behaviour that has to be covered up’ [Hasselström, (2003), p.152]. Since the insiders and semi-insiders are breaking the authorities’ rule regarding equal access to information by using unequal information when trading on the market, they are in effect playing in a broader, more shadowy market of sorts that operates beyond the narrower, officially transparent market in which the outsiders are playing. The outsiders are inside the narrower market at all times and in fact are the only ones that are actually playing in the official market. They are different from the insiders and the professional semi-insiders, who live on their abilities to trade with the outsiders and sell services to them. The outsiders believe they are playing according to rules ensuring equal access to information, while in practice equal access to information cannot exist. ‘Equal access to information’ is just a rule created by the authorities that is often broken. The idea of equal access to information is little more than an image for the public. By creating a fictitious dualistic drama between insiders and outsiders, insider trading regulation covers up its real mission to protect financial markets and financial businesses. Insider trading regulation camouflages customary trading practices through the presence of legislative authority giving an appearance that the trading conditions are fair. Inside information is actually the foundation of all financial markets, since all information necessarily has its origin as inside information. Someone always has to know something before everyone else knows it. No inside information means no markets, and if we want financial markets, inside information is good and no inside information is bad. In other words, if insider trading is immoral, so is the whole financial market. Moreover, the inside information must be spread slowly and successively on the market via insider trading or tipping, because if no information slips out before an official disclosure, markets will be too risky for the market professionals, who are managing thousands or millions of other peoples’ money, to take positions. There will be too much volatility, and buying stock will be too much like buying a lottery ticket. There must not be too much

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insider trading, however, because everyone must believe they have the chance to win, which appearance is best served by them actually winning from time to time. Bear in mind that the stock market is not a zero-sum game. It is possible for everyone to earn something. It’s just that the insiders earn more and the outsiders less.

5

Conclusions

That insider trading regulation is about the insider/outsider relationship is a fiction. The distinction between insiders and outsiders is a smoke-screen hiding the more realistic mission of the insider regulation to protect the semi-insiders, the intermediary middlemen. As we have described, it is neither possible nor desirable to eliminate insider information and insider trading from financial markets. If anything is ‘unfair’ about financial markets, it is not insider trading; rather, it is a financial system which invites the public to speculate on false promises and in which the individual is sacrificed for the sake of technological development and economic growth. The distinction between that which is equitable and that which is efficient is resolved in favour of the market makers who create the infrastructure for the efficient circulation and movement of risk capital. We have shown that the unusual origins of the insider trading regulations in Sweden were linked to the expansion of financial markets and the political strategy of stimulating financial speculation. If the purpose had indeed been to ensure equal access to information in a narrow sense, it is questionable how effective insider trading regulation has been. Interviews with Swedish insider trading investigators confirm that they can find only the illegal insider trading that is conducted in the limelight of the official list of insiders who have traded, that is, under the proverbial street lamp. Much of the illegal financial trading that is assumed to exist, tipping for example, is effectively out of sight, lurking somewhere in the darkness far from the light of the street lamp. It is really only the ‘clumsy lot’ that gets caught. But criminalisation of insiders’ trades can be justified independent of the actual efficiency in catching suspected insider traders. It all depends on what sort of ‘efficiency’ is at stake and how it is measured. It is less a matter of how many criminals have been detected, prosecuted, convicted and punished than it is a matter of its symbolic value. This symbolic value, which is supposed to create behavioural norms that result in changes in real behaviour, is regarded by the legal scholars who have taken an interest in insider trading regulation as a bonus supplementing the main objective of catching criminals, by which the efficiency of a law is usually measure. But in reality it is the other way around; it is the symbolic value that is the main objective and catching criminals that is the supplemental bonus. What is at stake is the symbolic image rather than the real actions, the perception of unfairness rather than actual personal injury. It is distrust that is to be eliminated and not really asymmetric information, which cannot be. The concepts of ‘fairness’, ‘equal opportunity’ and ‘symmetric information’ associated with the insider trading regulation are largely mental pictures confined to our minds, fictions with no significant link to, or bearing on, reality other than their ability to increase public confidence and stimulate financial speculation. We cannot claim that insider trading is not unfair, or that it does not exist, or that it is not hindered by insider trading regulation, but we do claim that real fairness, real existence, and real elimination are much less significant than their images.


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Economic regulations are in general productive rather than restrictive, aimed at not only sustaining markets but also at stimulating markets in which new products and new jobs are created. Towards this end, insider regulation is intended to create a new reality and not merely control the reality that is already here. Since the authorities are interested in pursing illegal insider trading to secure confidence in financial markets in the eyes of the public and since in the course of doing so the protection of the financial system is put before the protection of any individual, whatever confidence may result is not really justified. Especially through the use of the cross-border trading that the deregulation and internationalisation of financial markets has facilitated, there are ample opportunities for informed traders to both manipulate markets and trade on their private information. The intent and the outcome of insider trading regulation has been to stimulate financial speculation and expand the financial sector and not really to promote a fair and ethical society. The insider/outsider drama about which much is made is a curtain which conceals the real protected interests of the market makers, the professional players who sustaining the ‘money game’.

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Notes 1 2 3

4 5 6

‘Ds’ stands for Departement skrift, which is an official report published by a Swedish government department, in this case the Department of Finance. This process has striking similarities to the current US ‘War on Terror’ and ‘Homeland Security Act’. In the USA, outside investors have sued corporate insiders ‘indirectly’ for damaging the company by their trades, such actions being called ‘derivative suits’. However, the courts have either dismissed these cases or ruled in favour of the corporate directors by appealing to the old ‘no duty rule’, that is, there is no duty to disclose information before trading. So the strategy has proven to be a dead end [Bainbridge, (2001), p.57]. All translations from Swedish have been made by one of the authors. An ‘SOU’ is an official Swedish government report. An ‘FI’ report is produced by the Swedish Financial Services Authority (Finans inspecktionen), a government agency.