Insider Trading: Whither Wall Street’s Future?

As the global economy continues to emerge from the economic collapse of 2008, good times appear to be returning to Wall Street. Indeed, bankers’ year end holiday bonuses are on the rise, stoking growth throughout the New York City metropolitan region.

But while investment bankers party like it’s 1999 in lower Manhattan, the federal government is stepping up its inquiries about insider trading practices. Some commentators believe that our regulatory authorities are about to launch the mother of all enforcement actions.

Many argue that such a move would completely demolish the public’s faith in the financial markets, and thus would kill our nascent economic recovery. Others, though, assert that Wall Street itself has bred a culture of distrust in the essential fairness of the financial system; they believe that a massive enforcement action is long overdue.

A History of Insider Trading

Believe it or not, insider trading was actually a perfectly legal activity in the United States for much of our economic history. In fact, firms were not even required to issue audited financial statements to their own public investors until the newly formed Securities and Exchange Commission (SEC) began enforcing that requirement in 1933.

Some analysts, though, believe that the SEC now imposes too many regulatory constraints on our financial system. Adherents to the Efficient Market Hypothesis believe that transaction prices will inevitably self-correct as privately known information becomes public knowledge, thereby ensuring that traders will never reap significant profits from their personal knowledge of corporate secrets. These analysts believe that insider trading regulations serve no useful purpose; instead, they place a costly reporting burden on publicly traded firms.

Such arguments have driven much of the growth of the private equity markets, associations composed of private organizations that claim to be far more efficient (and thus far more profitable) than the public investment markets. Last week’s announcement that Del Monte will once again be taken private appears to support the assertion that the burdens of public disclosure of financial data may actually hinder the growth of major corporations.

During the past several years, though, financial institutions have begun to engage in various trading practices that raise troubling questions about the essential fairness of our market system. These questions appear to represent the primary impetus for the vast insider trading investigation now being launched by our regulators.

Transparency and Level Playing Fields

Concerns about our financial markets appear to be focused on a pair of fundamental principles; one involves the general goal of market transparency, and the other involves the specific objective of a level playing field. The reputed existence of an insidious insider trading culture tends to undermine both of these considerations.

The goal of transparency refers to the principle that each investor, regardless of his level of power and wealth, should have the ability to understand how market prices are established and how transactions are consummated. The objective of a level trading field refers to the principle that even the largest, wealthiest, and most powerful investors should use the same fundamental mechanisms to research opportunities and place trading orders as the smallest of investors.

Any market practice that allows huge investment organizations to secure special privileges that are not understood by (or are not accessible to) small investors  would undermine faith in these two principles, and would therefore jeopardize confidence in the system itself. Thus, investors who gain access to private information about companies, and who possess the ability to trade on such information before the general public learns about it, jeopardize the very system that enriches them.

Of Soft Dollars and Dark Pools

Concerns regarding transparency flared last week when news of soft dollar accounts at major investment institutions surfaced in the press. This followed earlier reports of robo-signers at banks that are foreclosing on supposedly delinquent mortgages without actually possessing the legal right to do so, while potentially innocent citizens are rendered homeless without any understanding of their own right to defend themselves.

Concerns regarding a level playing field have been surfacing for several years, beginning with rumors of mysterious dark pools of private funds that engage in instantaneous flash trading of securities. Such pools, as well as the private markets whose trades purportedly triggered the infamous Flash Crash of early 2010, enable wealthy institutions to rush to the markets and consummate transactions far more quickly than the average investor.

Will the federal government’s impending insider trading investigation address these concerns and enforce permanent changes in market behavior? Or will it soon be forgotten, like the SEC’s brief prosecution of Goldman Sachs? Some are hoping that this regulatory storm will soon pass, allowing Wall Street to continue focusing on the task of generating capital for rebuilding our economy. Others, though, are hoping for a far more fundamental restructuring of Wall Street’s culture, one they believe is necessary to support our nation’s future.