Insider trading: a law with doubtful efficiency
27 January the Federal Law `On Prevention of Illegitimate Use of Inside Information and Market Manipulation` passed last summer came into force. Generally, the Russian and international public opinion supports the ideas laid down in the law. Insiders` benefit shall be considered unfair and unjust by default. Acts aimed at profiting from using inside information must be penalized (in accordance with the administrative or criminal law). More than ninety countries have passed anti-insider laws, and more than forty of them practice punishing market players for insider trading (IT). As if to prove the rightness of the undertaken course, the US Galleon case has been going on for more than a year. Many famous economists (including Eugene Fama and Kenneth French) back up the ban on the unlawful use of inside information, but in our vision this measure is somewhat dubious.
There are a host of theoretical and empirical investigations that cast doubt on the tenet suggesting that IT is harmful. Albert Kyle showed in his classical 1985 article that exploiting monopoly power over insider information (II) did not contradict efficient price formation in the market.
Harold Demsetz proved that an opportunity to make profit from using II encouraged, not prevented, disclosure of information. Brokers represent one of the most important channels to communicate inside information to market players. Lisa K. Meulbroek's empirical investigations revealed that insider trading in shares did not cause other participants' portfolio profitability to fall. Milton Friedman advocates legalization of IT, arguing that any transaction increases the volume of market information. The IT legislation theoretical base seems to remain quite weak. The legislative norms can be expected to soften over time: punishment should be administered, first of all, for illegal disclosure of information to third parties, i.e. for the violation of confidentiality agreements.
As for Russia, it is not a secret that officials and company heads enjoying close relationships with the government are in this or that way involved in a large part of insider transactions and market manipulations. Will the government be able to fight those given our judicial and law enforcement system remains as it is now? Most likely, it will not. Russia still has to go a long way towards real law enforcement in the area of IT prevention. It may sound as a paradox, but this is not the worst possible option. Strict law enforcement would most likely leave Russia without a stock market. Anyway, long-term investors should first of all be concerned with the general legal situation in the country rather than insider trading.
By Vladimir Kreindel,
IFS senior analyst
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