Insider trading is far more prevalent and sophisticated than prosecutions suggest, according to worrying new research.
The mechanisms employed by perpetrators to stay undetected are evolving, painting a sobering picture of the scale and complexity of this illegal practice.
A paper, by academics Vinay Patel and Tālis Putniņš, suggests that traditional patterns of buying or selling shares based on non-public information may be the tip of the iceberg.
Four-times greater
"We estimate that the actual prevalence of illegal insider trading is at least four times greater than the number of prosecutions. Using structural estimation methods that account for incomplete and non-random detection and hand-collected data of all US-prosecuted insider trading cases, we estimate that insider trading occurs in one in five mergers and acquisitions and in one in 20 earnings announcements," the pair said.
One of the most notorious examples of insider trading was the case of Martha Stewart, the lifestyle guru, who was convicted in 2004 for the crime.
Stewart sold her shares in the biopharmaceutical company ImClone Systems based on a non-public, insider tip that the Food & Drug Administration was about to reject the company's new drug, thereby avoiding a substantial loss when the stock price subsequently plummeted
Today, insiders are leveraging a host of advanced financial instruments to camouflage their activities.
These tools range from complex derivative instruments, which enable the individual to profit from movements in the underlying asset without directly trading it, to the use of Exchange-Traded Funds (ETFs), which can mask the true intention of the trade due to their diversified nature.
The authors found that insiders cleverly take advantage of the higher liquidity conditions often found in derivatives and ETFs. This makes it considerably difficult for authorities to trace any irregularity back to its source.
Advanced detection needed
Moreover, the research reveals that insider trading is far higher than the number of prosecutions for it. This underlines the need for regulators to adopt more advanced detection mechanisms.
Despite the efforts made by bodies such as the Securities & Exchange Commission (SEC), the investigation highlights a worrying disparity between the occurrence of such illegal trading practices and their detection rate.
"Key drivers of the propensity for insider trading include the value of the information, the number of people in possession of the information, and the stock’s liquidity," the academics said in their paper."
"Detection and prosecution are more likely when there are abnormal trading patterns and more regulatory resourcing.
Hiding trades
When examining the effectiveness of different methods of avoiding regulatory scrutiny, Patel and Putniņš's research points to derivative-based tactics as one of the most effective.
Due to their complex nature and higher liquidity, these methods provide a smokescreen for illicit activities. However, the least effective method seems to be direct stock trading. This approach leaves a more obvious trail, making it easier for authorities to detect and prosecute.
The findings underscore the scale of the challenge faced by authorities in policing modern financial markets.
If insider trading is to be curbed, a more nuanced approach will be required, one that keeps pace with the sophisticated methods used by those determined to exploit privileged information for personal gain, the pair concluded.
"Despite the significant resources devoted to combatting illegal insider trading, it remains pervasive, although no one knows quite how pervasive," readers of the 57-page research paper were told.