The policy behind the crackdown on insider trading
Many people – myself included – are puzzled by the fact so few of the architects and builders of the corporate structures that came crashing down in the global financial crisis have been held to account for their criminally negligent workmanship. How can investors have confidence in the financial system, one might ask, when those responsible for such staggering losses walk away wealthy and unpunished?
Regulators around the world protest that such concern is misplaced. We are on the beat, say the corporate cops, doing what is necessary to protect investors, and the proof of our effectiveness is found in the aggressive pursuit of insider traders.
A case in point: when Lanny Breuer, until recently the head of the Criminal Division of the US Department of Justice, was asked why his prosecutors had not even come close to indicting a major Wall Street firm for GFC-related financial crimes, he told his interviewer to “take a step back”. The GFC, said Breuer, was “multifaceted”, and his team had successfully pursued a “multipronged, multifaceted response” to the crisis. But by Breuer’s own account, the only successful prosecution of a Wall Street player that resulted was the insider-trading conviction of Raj Rajaratnam, a hedge fund manager.
In Australia, the story is similar. While the Australian Securities and Investments Commission apparently found no chargeable wrongdoing in the collapses of Allco, Babcock & Brown or RAMS, for example, it has made sure to publicise the many recent insider-trading convictions it has achieved.
But it is not clear that cracking down on insider trading does much to protect ordinary investors and their savings. Indeed, making insider trading a scapegoat for the many ills of our financial markets gives investors a misleading impression of how markets work and where the real risks lie. (Full disclosure: I have acted as a lawyer for persons subject to insider-trading investigations.)
I’m loath to knock the regulators for enforcing the law and getting convictions. Insider trading is a serious criminal offence. Parliament recently doubled the penalty to 10 years’ imprisonment per offence, reflecting public anger at those who make money by cheating on the financial markets. But the fact remains that even the most well-organised and aggressive insider-trading conspiracies do not create a significant risk of direct loss to ordinary investors. In many cases, an innocent investor who sells his shares to a person who is trading with the benefit of inside information profits from the crime along with the perpetrator: the insider trader creates more demand for the shares being sold, and thus the “victim” does better financially.
Indeed, the true victims are typically not “mums and dads” but rather the sophisticated market participants whose proprietary information has been purloined. Rajaratnam, for example, traded on information that was effectively stolen from Goldman Sachs.
To be sure, there is an argument that the real harm is the general loss of confidence in the integrity of the markets. If investors come to believe the sharemarket is rigged to favour insiders, they will invest less, leading to higher costs of capital and less funds available for businesses to grow the economy, employ workers and pay dividends to shareholders. There is some academic literature to support this view. But there is a fatal conceit to the policy assumption behind the crackdown on insider trading – that elimination of this form of cheating should give “mum-and-dad” investors the confidence to dive into the sharemarket.
Don’t kid yourself. The sharemarket will never be an even playing field, and amateur investors will always be at a massive informational disadvantage compared with the professionals. The hedge funds and investment banks that generate most of the volume on any sharemarket make their trading decisions on the basis of advice from highly trained professionals who spend practically every waking moment thinking about the value of shares. That is, of course, if the hedge fund even relies on humans to make trading decisions. Significant volume is generated by algorithmic trading, executed by computers programmed to identify and exploit even the most fleeting share price discrepancies. The notorious “high frequency traders” are able to respond to new market information within milliseconds, and part of their competitive advantage rests in being so physically close to the exchange that they can place their orders thousandths of a second before their competitors.
The war on insider trading is premised on the assumption that, as a policy matter, ordinary retail investors should be encouraged to believe that share trading is an even playing field. That makes about as much sense as asking a team of under-13s to take on the All Blacks.
Our policymakers would do well to listen to the greatest investor of all time, Warren Buffett. Buffett says that non-professional investors, if wise enough, will conclude that they just don’t know enough about the arcane art of corporate valuation to make sensible stock-picking decisions. The wise amateur will look to diversify, to keep her costs minimal, and to accumulate shares over a long time and hold on to them.
Buffett recommends investing in low-fee passive index funds: baskets of shares that track the overall performance of the sharemarket, and thus the broader economy. As the economy grows, so too does the value of the portfolio. In the long run, in Buffett’s estimation, such a wise amateur will outperform the semi-knowledgeable investor who thinks he has the smarts to beat the market. Buffett’s wise amateur will also be practically immune to direct losses from insider trading, as temporary price blips caused by shonks and spivs gaming the system are irrelevant to her.
Buffett’s message is not likely to be welcomed, however, by those who have the ears of our policymakers. Australia’s compulsory superannuation system is an unending waterfall of money flowing into the sharemarket and other investments, and there is a vast horde of politically connected financial advisers and “investment managers” who gather around that waterfall, hoping to get drenched from the spray.
These people have a vested interest in keeping retail investors out of index funds and the like, and that’s why the Grattan Institute’s recent recommendation that superannuation investors be offered a low-fee default fund was dead on arrival. The retail superannuation lobbyists want investors to be confident: confident to churn in and out of stocks or – even better – confident that their adviser will, for a fee, pick stocks for them. For these people, the war on insider trading is part of the marketing.
In an era of swingeing budget cuts, expect ever more reliance from the regulators on data-mining computers to detect insider traders, rather than on detailed forensic investigations of the complex corporate crimes that cause real and massive losses to ordinary investors.
But don’t expect the headline grabbing insider-trading prosecutions to do much to make markets safer for amateurs, or to protect “mum-and-dad” investors from the true predators.
This article was first published in the print edition of The Saturday Paper on Aug 16, 2014 as "Trading in confidence". Subscribe here.