An inquiry into the nature and causes of insider trading Master Thesis Tilburg School of Economics and Management Finance MSc September 26, 2014 Author: Supervisor: R.V.A. Manders Dr. R.G.P. Frehen s646397 Table of Contents 1. Introduction .............................................................................................................................................. 2 2. Literature review ....................................................................................................................................... 4 3. Historical background ................................................................................................................................ 7 4. Data ......................................................................................................................................................... 11 Descriptive statistics & preliminary analysis ........................................................................................... 13 5. Inquiry I: learning from insiders .............................................................................................................. 18 Methodology ........................................................................................................................................... 18 Analysis of results .................................................................................................................................... 19 6. Inquiry II: Insider trading ......................................................................................................................... 20 Methodology ........................................................................................................................................... 20 Analysis of results .................................................................................................................................... 23 7. Conclusion ............................................................................................................................................... 30 Acknowledgements ..................................................................................................................................... 31 Bibliography ................................................................................................................................................. 31 Appendices .................................................................................................................................................. 33 Appendix A .............................................................................................................................................. 33 Appendix B .............................................................................................................................................. 34 Appendix C............................................................................................................................................... 35 Appendix D .............................................................................................................................................. 36 Appendix E ............................................................................................................................................... 38 Appendix F ............................................................................................................................................... 39 1 1. Introduction The academic debate on whether to regulate insider trading has been going on for many years. Plain said: one side calls for regulation, another against. The side that supports deregulation says that insider trading leads to better security pricing (market efficiency), which is beneficial to society as it improves the allocation of capital. The prime economic argument of those pleading for regulation is that insider trading reduces the appeal of stock markets to investors. They state that because of the unjustified profits to insiders at the expense of investors, people will be more reluctant to participate in the equity market and risk premiums will increase, which would diminish the use of financing through joint stock companies. Even though fairness is an important issue in this debate, few scholars ask whether the outsider who is harmed by this unfair insider trading had a fair chance to detect the insider activity, let alone whether he is a poor trader who often conducts ill-advised trades, irrespective of insider trading. It is probable that counterparties, as a group, share certain characteristics that explain why they traded with insiders. There is a widespread belief in the investment community that insiders possess valuable information that is exclusive to them. For that reason the investment community takes an interest in trading by insiders. This might limit profits to insider trading through a price run-up caused by outsiders who learn about insider activity. Therefore, it makes much sense for insiders to hide their trading activities from the market, regardless of regulation. Similarly, it makes sense to outsiders to find out about insider trading. So if counterparties, for example through their broker or market talk, would find out about insider trading and reverse course, this would be a significant limitation to insider trading. Very little research has been done on insider trading in an unregulated environment and still less with full access to trading data of all insiders and outsiders. Using hand-collected microstructure data from 18th century London, I analyse the stock trading by Bank of England directors and their counterparties in great detail. Whereby the purpose of this study is to learn whether insiders can freely make trading profits in an unregulated market and how this affects or hurts their counterparties. I find evidence that counterparties of insiders only suffer when trading with insiders, not when trading with fellow outsiders. This is found in a market quite similar to modern markets with respect to privacy of insiders in the market. This thesis is divided into seven sections. Section 2 gives an overview of relevant present literature on the field of insider trading. Section 3 provides necessary historical background. Section 4 describes the 2 data. Section 5 is the analysis of learning from insiders by the sub question: did counterparties of insiders start to trade in the same direction as the insiders after their ill-advised trade? Section 6 analyses insider trading and its effect on counterparties by the following questions: did insiders engage in profitable insider trading in the unregulated 18th century London market? Did counterparties underperform as a result of insider trading? And if so, what caused this loss? Section 7 contains the final conclusion and recommendations for future research. 3 2. Literature review This chapter is structured according to four themes that are relevant to multiple research questions each. The first part, returns to insider trading, looks into what results could be found depending on market conditions. The second part summarizes literature on how detection of insider trading should work. The third part, literature on the insider trading debate, explains an important concept for the debate on the fairness of insider trading. Fourth, the limits on insider trading in the 18th century markets are discussed. Returns to insider trading Most studies on insider trading study the regulated market. There has been contradicting evidence as to whether or not insiders can generate short-run abnormal returns in that sort of market. A somewhat more medium-term approach finds that insider trading predicts aggregate returns 6&12 months ahead (Seyhun, 1992). This notion could be helpful in this study, as like in the contemporary regulated market insiders in 18th century England did not have specific information linked to a clear time window, but rather overall superior information about a company. Friedrich et al. (2002) find that insiders engage in market timing on the London Stock Exchange and that their trades have slight short-term predictive power in that regulated market. They also find that stocks after insider buy trades show higher abnormal returns than after sell trades. This makes sense, as a buy trade has only one explanation: the stock is a good buy according to the insider. A sell trade can have numerous reasons that are unrelated to the stock; a director might sell shares for liquidity reasons. Friedrich et al. also find that short run insider trading stock returns are statistically significant, but not economically. They find clustered trades and trades of medium size to be more informative. The explanation is consistent with the stealth trading hypothesis (Barclay & Warner, 1993). This says that insiders probably try to conceal their information by trading cautiously. As this study concerns trading by insiders at least 2 months before earnings reports, we may conclude that the returns are not necessarily due to informed trading, but perhaps a capability of insiders to assess the value of the company. On trade volume, prices, and detection of insider trading One can see prices as a system to communicate information (Hayek, 1945). From this notion by Hayek, the theory of price decoding emerged that says that when a stock price deviates from its fundamental value, the only logic explanation must be the occurrence of informed trading. And that price effect leads outsiders to discover insider