Insider dealing: breaking the information monopoly in the stock market

In 2011, the US financial world was rocked by a scandal when the founder of the Galleon Group. Raj Rajaratnam was convicted of 14 insider dealing offences. Rajaratnam, once one of Wall Street's most influential investors, illegally made millions of dollars by exploiting confidential information about technology companies. This case has once again brought into focus the dangers of insider dealing and the need to combat it.

In stock markets, it is important to have information in order to succeed. But what happens when information is not equally available to all? Insider trading gives an unfair advantage to those with access to confidential information, harming honest investors and undermining market credibility. In this article, we will dive deeper into the world of insider dealing to understand how it works, its consequences and how to curb it.

Why is it important to fight insider dealing? Because they distort the functioning of markets, prevent the efficient allocation of capital and undermine faith in the fairness of the financial system. Curbing insider dealing is therefore essential both to protect investors and to safeguard a healthy business environment.

Information advantage: what counts as "inside information"?

Insider dealing gives an advantage to those who have information that others do not. But what exactly is "insider information"? It's not limited to secrets overheard at company board meetings. Insider information is any information that:

Not public: Information is not available to the wider investor community through press releases, stock exchange announcements or other public channels.
It is important: The information is significant enough that it could affect the share price if it were to become public.
It is accurate: The information is not mere rumour or speculation, but based on reliable sources.

For example, insider information could be:

Takeover: If someone knows in advance that a company is going to be taken over, he or she can buy shares before the information is made public, because a takeover bid usually pushes up the share price.
Launching a new product: If someone knows that a company is planning to launch a revolutionary product that is better than expected, they can buy shares before the product is unveiled.
Financial results: If someone knows in advance that a company's financial results will be better or worse than expected, he or she can buy or sell shares accordingly before the results are published.

In addition to direct access to internal company information, insider information may also include information obtained "mosaic theory" basis. This means that combining and analysing publicly available information gives an unfair advantage because it allows conclusions to be drawn that other investors have not yet drawn.

It is also illegal to pass on inside information to other persons ("tipping"). This is true even if the person providing the information does not directly profit from it.

The boundaries for the possession and use of inside information are therefore quite broad. It is important to understand that anyone who has access to confidential information has a duty to protect that information and not to use it for personal gain.

Why are insider dealing illegal?

Insider dealing is not just an ethical issue. They violate the basic principles of how markets work and damage the financial system as a whole. Here are some of the main reasons why insider dealing is illegal:

Undermining market confidence:

Trust is the basis on which stock markets work. Investors must believe that they have equal access to information and that the market is fair and transparent. Insider dealing undermines this trust by giving an unfair advantage to those with access to confidential information. This, in turn, undermines investor confidence in markets and discourages investment.

Harming honest investors:

Insider dealing harms honest investors who do not have access to confidential information. If someone knows in advance that Share the price rises, he can buy shares before the price rises and sell them afterwards, thereby making a risk-free profit. This harms other investors who buy shares at a higher price and sell them at a lower price.

Reducing market efficiency:

An efficient market is one where share prices reflect all publicly available information. Insider dealing distorts share prices and prevents markets from performing their function. This, in turn, reduces the efficient allocation of capital and harms economic growth.

Distorting the price discovery mechanism:

Share prices are the result of a market balance between supply and demand. Insider dealing distorts this balance by giving an unfair advantage to those with access to confidential information. This, in turn, distorts the price discovery mechanism and prevents markets from fulfilling their function.

Academic research and statistics:

Several academic studies have shown the negative impact of insider dealing on markets. For example, insider trading has been found to increase volatility and reduce liquidity. Insider dealing has also been found to reduce investor confidence in markets and discourage investment.

Regulations in different countries:

Insider dealing is illegal in most countries. Penalties for insider dealing vary, ranging from fines to imprisonment. Some countries have stricter insider trading regulations than others. For example, in the US, insider trading regulations are very strict and penalties are severe.

Ultimately, insider dealing is illegal because it undermines market confidence, harms honest investors and reduces market efficiency. Tackling insider dealing is essential to ensure a fair and transparent market that promotes investment and growth.

Detecting and monitoring insider dealing: will the "whistleblowers" always go untracked?

Although insider dealing is often hidden, it is not undetectable. Regulatory authorities, such as the Financial Supervision Authority in Estonia, are constantly monitoring the market and investigating suspicious transactions. They have a range of tools and methods at their disposal to help them track down insider dealing.

Technology and data analysis:

Today's regulators have access to powerful technologies and databases that allow them to analyse vast amounts of transaction data. Algorithms are able to detect unusual trading patterns that may indicate insider dealing. For example, if someone buys an unexpectedly large amount of shares just before an important news story is published, it could be a sign that they had access to confidential information.

Monitoring methods:

In addition to data analysis, regulators also use other supervisory methods:

Anonymous tip systems: The Financial Supervision Authority has an anonymous tip-off system that allows people to report suspicious transactions. This is an important source of information, as it is often the company's insiders who first become aware of insider dealing.
Cooperation with other countries: Insider dealing is not limited to national borders. Regulators work closely with other countries to share information and coordinate supervision.

Challenges:

Despite efforts by regulators, detecting insider dealing remains difficult. "Info-cats" often use sophisticated schemes and covert transactions to cover their tracks. For example, transactions may be carried out through offshore accounts or cryptocurrencies. This poses additional challenges for regulators.

The future:

As technology evolves, so do the methods for detecting insider dealing. Artificial intelligence and machine learning can be used to analyse even larger volumes of data and identify complex trading patterns. This will help regulators to fight insider dealing more effectively and ensure fair and transparent markets.

Investors' role and responsibility: everyone can contribute

Tackling insider dealing is not just a task for regulators. Investors also have an important role to play in ensuring a fair and transparent market. Everyone can contribute by being informed and responsible.

How can investors contribute?

Be aware: Learn about the nature and consequences of insider dealing. The better you understand them, the better you will be able to recognise and protect against them.
Pay attention to corporate governance and ethics: Invest in companies that value transparency and ethical behaviour. Investigate the company's governance structure and how they view the prevention of insider dealing.
Report suspicious transactions: If you suspect someone of insider dealing, report it to the Financial Supervision Authority. Your information may be important to help regulators start an investigation.
Follow ethical investment principles: Make investment decisions honestly and transparently. Don't try to gain an unfair advantage over other investors.
Be an active owner: If you are a shareholder, attend company general meetings and ask questions of management. Demand transparency and accountability.

Why is the role of investors important?

Investors are an important part of the market. Their behaviour and decisions affect the functioning of markets. If investors are informed and responsible, this contributes to fair and transparent markets.

Summary

Fighting insider dealing is an ongoing process that requires cooperation between regulators, investors and companies. Everyone has a role to play in this process. It is important to be aware, responsible and proactive to ensure fair and transparent markets that promote investment and growth.