traders improperly obtain from other sources.In most countries, insider trading is illegal and is punishable by fines or imprisonment. Insidertrading laws are very difficult to enforce, however. Only a few countries—primarily the UnitedStates, Canada, and Britain—regularly and seriously attempt to enforce their insider-tradinglaws.Insider trading has many economic effects. In the financial markets, it affects investorconfidence, price efficiency, and liquidity. In the overall economy, insider trading affects thelabor market for senior corporate managers, and the quality of management decisions that theseexecutives make.In this chapter, we define insider trading and explain how regulators enforce insider-tradinglaws. We then consider the debate over whether to restrict insider trading. As we debate the twosides of the issue, we will identify the effects that insider trading has on the markets and on theoverall economy.If you trade, you must recognize insider information to avoid making illegal trades. Moregenerally, you must understand insider trading to fully understand market liquidity. Finally, andperhaps most unexpectedly, you must understand the effects of insider trading on manageriallabor markets to fairly interpret comparisons of senior executive compensation across countries.29.1 Inside Information and Insider TradingInsider trading and inside information are hard to define. Both are complex legal concepts thatare subject to substantial interpretation. If you are confronted with an issue that may involveinsider trading, you should consult a competent attorney.
An SEC Definition of Insider TradingStatuary laws, the government regulations that implement them, and the case law created bysuccessful and unsuccessful attempts to prosecute inside traders define insider trading. As apublic service, the US Securities and Exchange Commission provides a one paragraph summarydefinition of insider trading on its web pages:“Insider trading” refers generally to buying or selling a security, in breach of a fiduciaryduty or other relationship of trust and confidence, while in possession of material,nonpublic information about the security. Insider trading violations may also include“tipping” such information, securities trading by the person “tipped” and securitiestrading by those who misappropriate such information. Examples of insider trading casesthat have been brought by the Commission are cases against: corporate officers, directors,and employees who traded the corporation's securities after learning of significant,confidential corporate developments; friends, business associates, family members, and
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other “tippees” of such officers, directors, and employees, who traded the securities afterreceiving such information; employees of law, banking, brokerage and printing firmswho were given such information in order to provide services to the corporation whosesecurities they traded; government employees who learned of such information becauseof their employment by the government; and other persons who misappropriated, andtook advantage of, confidential information from their employers.This one paragraph summary nicely illustrates the complexity of the law on insider trading.Source: www.sec.gov/divisions/enforce/insider.htm (January 4, 2002)
The primary purpose of this chapter is to help you understand the economic issues that surroundinsider trading. For this purpose, we define inside information as material information about thevalue of a security that is not available to public traders. Material information is informationthat would cause prices to change if it were widely known. In the equity markets, corporatemanagers control most inside information.In jurisdictions that prohibit insider trading, nobody can trade on inside information until afterthe information is publicly available. In particular, corporate managers cannot trade on theinformation nor can their friends nor can the friends of their friends. Inside informationgenerally retains its status regardless of how many people have passed it. You may not trade ona stock tip that you receive from your barber who received it from another client who received itfrom a corporate insider, if the tip is based on inside information. Inside information loses itsspecial status only when it becomes available to the public. After a firm releases information tothe public through a broadly distributed press release or through a public filing, the informationis publicly available.Texas Gulf SulfurIn late 1963, Texas Gulf Sulfur discovered very valuable deposits on copper, zinc, and silver inOntario. Between November 12, 1962 and April 16, 1964, officers, directors, employees, andtheir friends bought Texas Gulf Sulfur stock and call options. During this period, the stock pricerose from 173/8 to 293/8 dollars.The company, however, did not disclose information about the find until April 12, 1964. On thatdate, it merely revealed that its drilling had “not been conclusive” and that “the rumors about thediscovery were unreliable … premature and possibly misleading.” Four days later, on April 16,the company announced a major ore discovery. Following the announcement, the stock pricerose to 71 dollars.The Securities and Exchange Commission sued various directors, managers, and employees ofTexas Gulf Sulfur alleging insider trading and deliberate efforts to mislead the public. The suitwas successful.Source: Facts paraphrased from Jie Hu and Thomas H. Noe, “The Insider Trading Debate,” Federal Reserve Bankof Atlanta Economic Review, Fourth Quarter 1997, p. 36.
Sometimes, information that traders do not obtain directly from management is insideinformation. For example, suppose that a financial printer prints a prospectus for a takeoveroffer. While operating the presses, a pressman reads the copy and calls a friend to tell him tobuy the target. The friend will be trading on insider information.©2002 Oxford University Press
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Vincent Chiarella, the PrinterIn 1975 and 1976, Vincent Chiarella worked as a "markup man" in the New York composingroom of Pandick Press, a financial printer. Among the documents that he handled were fiveannouncements of corporate takeover bids. When these documents were delivered to the printer,the identities of the acquiring and target corporations were concealed by blank spaces or falsenames. The true names were sent to the printer on the night of the final printing.Chiarella, however, was able to deduce the names of the target companies before the finalprinting from other information contained in the documents. Without disclosing his knowledge,he purchased stock in the target companies and sold the shares immediately after the takeoverattempts were made public. By this method, Chiarella realized a gain of slightly more than30,000 dollars in the course of 14 months. Subsequently, the Securities and ExchangeCommission began an investigation of his trading activities. In May 1977, Chiarella entered intoa consent decree with the SEC in which he agreed to return his profits to the sellers of the shares.On the same day, Pandick Press discharged him.Chiarella was later convicted of 17 counts of violating Section 10(b) of the Securities ExchangeAct of 1934 (1934 Act) and SEC Rule 10b-5 under the principle that Chiarella owed aresponsibility to the sellers to disclose his information. In 1980, the US Supreme Court reversedthe conviction because he had no fiduciary duty to the acquiring or target firms.The law has subsequently changed. If Chiarella were brought to trial now, he would beconvicted of insider trading because he misappropriated information.Source: The first two paragraphs of this box are taken almost verbatim from Section I of the Supreme Courtdecision in Chiarella v. United States, 445 U.S. 222 (1980). The decision appears atcaselaw.lp.findlaw.com/scripts/getcase.pl?court=us&vol=445&invol=222.
Managers must control the dissemination of material information. In particular, they must eitherkeep it secret or widely distribute it. When they distribute confidential information to businessassociates, they must execute confidentiality agreements. If managers distribute insideinformation to their friends who then trade upon it, the managers risk prosecution.A Noble Cause and a Base ExplanationIn Fall 2000, the US Securities and Exchange Commission adopted Regulation FD. Thisregulation requires that “whenever an issuer … discloses any material nonpublic informationregarding that issuer or its securities to any person …, the issuer shall make public disclosure ofthat information … simultaneously, in the case of an intentional disclosure; and promptly, in thecase of a non-intentional disclosure.”Before the adoption of Regulation FD, corporations would frequently tell their analysts materialinformation before they reported it to the public. The analysts, their clients, or both would thentrade on this information.Not surprisingly, analysts adamantly opposed the new regulation. They claimed that it wouldmake security prices less informative. In particular, they argued that their reports would bemuch less informative if they could not privately interview management and ask them probingquestions. Without this privilege, they claimed that they would not be able to discoverincompetent or dishonest management.
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BibliographyThis bibliography provides selected references for further reading. I classified the referencesusing the chapter outline of this book. Since some articles and books cover topics that appear inmany of the chapters, the classification is somewhat arbitrary.The market microstructure literature has grown large very quickly. This bibliography thereforeis not comprehensive. I included many works because they provide the first clear presentation ofa principle or because they include extensive bibliographies of their topics. I included otherworks because I especially appreciated what I learned from them or because I found them to beparticularly well written.I undoubtedly failed to include many excellent works simply because I did not remember them.Although I am blessed with an excellent memory for ideas, I regrettably have a poor memory fornames. The omission of many excellent works from this bibliography therefore reflects more onme than on them.
General WorksBelonsky Gail M., and David M. Modest, 1993, Market microstructure: An empiricalretrospective, Working paper, Haas School of Business, University of California,Berkeley.Coughenour, Jay, and Kuldeep Shastri, 1999, Symposium on market microstructure: A review ofempirical research, Financial Review 34(4), 1-28Dalton, John M., ed., 1993. How the Stock Market Works (New York Institute of Finance, NewYork, NY).Downes, John, and Jordan E. Goodman, eds., 1991. Dictionary of Finance and Investment Terms(Barron’s Educational Series, New York, NY).Fan, Ming, Sayee Srinivasan, Jan Stallaert, and Andrew B. Whinston, 2002. ElectronicCommerce and the Revolution in Financial Markets (South-Western, Mason, OH).Kalman J. Cohen, Steven F. Maier, Robert A. Schwartz, and David K. Whitcomb, 1986. TheMicrostructure of Securities Markets (Prentice-Hall, Englewood Cliffs, NJ).Lee, Rubin, 1998. What is an Exchange: The Automation, Management and Regulation ofFinancial Markets (Oxford University Press, New York, NY).Lyons, Richard K., 2002. The Microstructure Approach to Exchange Rates (The MIT Press,Cambridge, MA).Madhavan, Ananth, 2000, Market microstructure: A survey, Journal of Financial Markets 3(3),205-258O’Hara, Maureen, 1995. Market Microstructure Theory (Basil Blackwell, Cambridge, MA).Schwartz, Robert A., 1991. Reshaping the Equity Markets: A Guide for the 1990s (HarperBusiness, New York, NY).©2002 Oxford University Press
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Sharp, Robert, 1989. The Lore and Legends of Wall Street (Dow Jones-Irwin, New York, NY).Stoll, Hans R., 1992, Principles of trading market structure, Journal of Financial ServicesResearch 6(1), 75-107Teweles, Richard J., Edward S. Bradley, and Ted M. Teweles, 1998. The Stock Market 7th ed.(John Wiley and Sons, Inc., New York, NY).Teweles, Richard J., and Frank J. Jones; Ben Warwick, ed., 1999. The Futures Game: WhoWins? Who Loses? And Why? 3rd ed. (McGraw-Hill, New York, NY).Wagner, Wayne, ed., 1989. The Complete Guide to Securities Transactions: EnhancingPerformance and Controlling Costs (John Wiley & Sons, New York, NY).
Chapter 3: The Trading IndustryBank for International Settlements, 2001. Triennial Central Bank Survey of Foreign Exchangeand Derivatives Markets Activity (Bank for International Settlements, Basel,Switzerland).Garbade, Kenneth D., and William L. Silber, 1978, Technology, communication and theperformance of financial markets: 1840-1975, Journal of Finance 33(3), 819-832Keim, Donald B., and Ananth Madhavan, 2000, The relationship between stock marketmovements and NYSE seat prices, Journal of Finance 55(6), 2817-2840Schwert, G. William, 1977, Stock exchange seats as capital assets, Journal of FinancialEconomics 4(1), 51-78Securities Industry Association, 2001. Securities Industry Fact Book (Securities IndustryAssociation, New York, NY).US Congress, General Accounting Office, 1986. Stocks and Futures: How the MarketsDeveloped and How They are Regulated, GAO/GGD-86-26 (General Accounting Office,Washington, DC).US Congress, General Accounting Office, 1991. Global Financial Markets: InternationalCoordination Can Help Address Automation Risks, GAO/IMTEC-01-62 (GeneralAccounting Office, Washington, DC).US Congress, Office of Technology Assessment, 1990. Electronic Bulls & Bears: US SecurityMarkets & Information Technology, OTA-CIT-459 (US Government Printing Office,Washington, DC).US Congress, Office of Technology Assessment, 1990. Trading Around the Clock: GlobalSecurities Markets and Information Technology—Background Paper, OTA-BP-CIT-66(US Government Printing Office, Washington, DC).
Chapter 4: Orders and Order PropertiesAngel, James J., 1998, Nonstandard-settlement transactions, Financial Management 27(1), 31-46
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Copeland, Thomas E., and Dan Galai, 1983, Information effects on the bid-ask spread, Journalof Finance 38(5), 1457-1469
Chapter 5: Market StructuresAmihud, Yakov, and Haim Mendelson, 1987, Trading mechanisms and stock returns: Anempirical investigation, Journal of Finance 42(3), 533-553Amihud, Yakov, Haim Mendelson, and Beni Lauterbach, 1997, Market microstructure andSecurities Values: Evidence from the Tel Aviv Stock Exchange, Journal of FinancialEconomics 45(3), 365-390Ball, Clifford A., Walter A. Torous, and Adrian E. Tschoegl, 1985, The degree of priceresolution: The case of the gold market, Journal of Futures Markets 5(1), 29-43Cohen, Kalman J., and Robert A. Schwartz, 1989, An electronic call market: Its design anddesirability, in Henry C. Lucas, Jr. and Robert A. Schwartz, eds.: The Challenge ofInformation Technology for the Securities Markets (Dow Jones-Irwin, Homewood, IL).Domowitz, Ian, 1993, A taxonomy of automated trade execution systems, Journal ofInternational Money and Finance 12(6), 607-631Fishman, Michael J., and Kathleen M. Hagerty, 1995, The mandatory disclosure of trades andmarket liquidity, Review of Financial Studies 8(3), 637-676Franks, Julian, and Stephen Schaefer, 1995, Equity market transparency on the London StockExchange, Journal of Applied Corporate Finance 8(1), 70-77Goodhart, Charles, and Ricardo Curcio, 1992, Asset price discovery and price clustering in theforeign exchange market, Working paper, London School of Business.Grossman, Sanford, and Merton Miller, 1988, Liquidity and market structure, Journal of Finance43(3), 617-633Harris, Lawrence, 1991, Stock price clustering and discreteness, Review of Financial Studies4(3), 389-415Ho, Thomas S., Robert A. Schwartz, and David K. Whitcomb, 1985, The trading decision andmarket clearing under transaction price uncertainty, Journal of Finance 40(1), 21-42Huang, Roger D., and Hans R. Stoll, 1992, The design of trading systems: Lessons from abroad,Financial Analysts Journal 48(5), 49-54Huang, Roger D., Stoll, H., 1996, Dealer versus auction markets: A paired comparison ofexecution costs on NASDAQ and the NYSE, Journal of Financial Economics 41(3), 313357Katz, Michael L. and Carl Shapiro, 1985, Network externalities, competition, and compatibility,American Economic Review 75(3), 424-440Lucas, Henry C., Jr., and Robert A. Schwartz, eds., 1989. The Challenge of InformationTechnology for the Securities Markets (Dow Jones-Irwin, Homewood, IL).Madhavan, Ananth, David Porter, and Daniel Weaver, 2000, Should Securities Markets BeTransparent?, Working paper, University of Southern California.©2002 Oxford University Press
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