Insider trading: definition, example, impact on the market

Insider trading: definition, example, impact on the market

One of the most sensational concepts in its time is insider trading —”delicate" area of the financial world . In this article we will cover this topic and explain under what conditions there is nothing wrong with this. We will also tell you what to do if the rules of insider trading are not followed or in cases where it was initially conceived with malicious intent.

Insider trading: what is it?

Insider trading is trading based on non-public information.

Non-public information — information that is not available to the general public. Public companies are required to make their reporting, personnel decisions, and management compensation publicly available. Reviews of products after release and corporate news are also available to the public. Accordingly, non-public information is financial statements before publication (available, for example, to company employees or an auditor), the quality of a new product (before early reviewers have access to it) and potential personnel decisions before their publication.

Відповідно, непублічною інформацією є фінансова звітність до публікації (доступна, наприклад, лише співробітникам компанії чи аудитору), опис якості нового продукту (до моменту відкриття доступу до нього раннім рецензентам) та потенційні кадрові рішення до моменту їх публікації.

Who is an insider

An insider is a person who has non-public information, such as a manager, analyst, or even a janitor at a company. Such people have access to more information than is publicly available and, accordingly, have an “unfair” advantage over other investors.

Just because you're an employee of a company doesn't mean you can't trade stocks or bonds of the company you work for. Considering that in many corporations, part of managerial bonuses are issued in the form of stock options or directly in treasury shares, a complete ban on trading in these assets would make this form of compensation meaningless. In this case, insiders are required to declare their transactions on the company's assets. Information on such transactions is made publicly available. This may take some time and, depending on the company and jurisdiction, may have different restrictions and nuances.

Information asymmetry in financial markets

Insider trading — one of the extreme expressions of such a concept as information asymmetry. 
Information asymmetry is a situation in which one of the parties to a transaction has a fundamentally larger amount of information than the other. In economic theory, market efficiency is achieved through the most efficient transactions. But in the real world, the seller and buyer may have different amounts of information and knowledge. Accordingly, the issue of information asymmetry arises.

Every investor must monitor situations where and why information asymmetry arises. At the regulatory level, this asymmetry is smoothed out due to general access to information, but a purely physically large bank with a separate, experienced department of analytics and traders will a priori be able to use publicly available information more effectively than a single investor.

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Why is insider trading prohibited

Let's look at a simple example of insider trading. Imagine that you work for a publicly traded company that is about to release a new product. You were involved in the development of this product. In order not to lead to significant changes in the share price before the launch, a silence regime was established at the company level on insider trading. As a participant in the development process, you know that the quality of the product is poor and is guaranteed to result in a significant reduction in the share price. You'd like to short a stock to make personal money, but you can't. But you have a friend who works in a financial company.

If you convey your skepticism to this acquaintance, he will short the shares with the company's funds and, naturally, some form of gratitude will be conveyed to you in one form or another. It would seem that this is illegal? But in fact, following the investigation, everyone who knowingly took part in this transaction will bear criminal liability.

In this case, insider trading takes place in its purest form. You violated a regime of silence, most likely a non-disclosure agreement, and harmed shareholders by illegally reducing the value of their shares before they could have received information about the quality of the new product.

In turn, your friend and all colleagues who knowingly participated in this operation violated the code of ethics for financial market employees. Together, you have conducted an operation that violates the principles of fair trade and public markets.

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The impact of insider trading on the market

Despite the active fight against insider trading, it still exists — earning double-digit % of the invested capital at once is too tempting.

Within the framework of maximum market efficiency, theorists consider that even inside information is incorporated into the market price. In fact, only within the maximum stage of market efficiency will insider trading be such a profitable activity.

Insider trading: how to fight

The fight against insiders is carried out by the competent authorities that regulate financial markets in the respective country. Do you know that someone is involved in insider trading? It is your responsibility to report this to the competent authorities, especially if you are a professional participant in the financial market.

Insider trading is a serious violation and misuse of a corporation's inside information. If during the investigation the investigative authorities find out that you knew everything, you may be tried as an accomplice.

Frequently asked questions: what is insider trading

How to identify an insider

Each company may have its own methods of identifying insiders who leak information and procedures for internal processing of suspicious transactions. It is the company's responsibility to ensure that these procedures are strictly followed. If necessary, relevant external services and experts are involved.v

What are the risks of insider trading

Insider trading is a punishable crime and the severity of the penalty may vary from jurisdiction to jurisdiction. For example, in the United States, insider trading is considered a criminal activity and is punishable by fines and prison sentences.