Informed Trading and Its Regulation

By Fox, Merritt B.; Glosten, Lawrence R. et al. | Journal of Corporation Law, Summer 2018 | Go to article overview

Informed Trading and Its Regulation


Fox, Merritt B., Glosten, Lawrence R., Rauterberg, Gabriel, V, Journal of Corporation Law


I. INTRODUCTION

Informed trading-trading on information or analysis not yet reflected in a stock's price-drives much of the stock market.1 Such information enables a more accurate appraisal of a stock's value than what its current price implies. The trader may have obtained this information from astute analysis of publicly available information, from public information that has just been disclosed and is not yet reflected in a stock's price, or from confidential information possessed by the issuer of the stock or by another entity, such as a potential acquirer.

No issue in securities law has garnered more attention from law and economics scholars and the larger public alike than insider trading, in which a trader transacts based on nonpublic information obtained from inside an issuer or another entity.2 The legal literature has thought far less about how the other forms of informed trading should be regulated and how current law in fact affects them already. The ambition of this article is to advance thinking on both fronts. To that end, we argue that both types of insider trading (by insiders within and without an issuer) are better regulated as part of the more general phenomenon of informed trading, and that securities regulation could better promote social welfare if it was designed with an awareness of what all types of informed trading have in common and how they differ.3

The basics of microstructure economics reveal that informed trading leads to more accurate share prices,4 which in turn increase the efficiency with which the economy allocates goods and services.5 However, informed trading also reduces market liquidity,6 which makes trading costlier and leads to a variety of inefficiencies.7 There is thus a fundamental tradeoffin how informed trading affects the two principal social functions served by equity markets-providing accurate prices and facilitating liquidity. This Article takes this basic tradeoffand uses the tools of microstructure economics, modern finance theory, and the theory of the firm to try to identify which forms of informed trade are in fact socially desirable, which are socially undesirable, and how to best regulate the market as a result. More specifically, we argue that given this difficult tradeoff, two key factors are crucial to determining the social utility of a trading practice-the strength of any incentives it provides for the generation of new information by traders and what one could call the "counterfactual latency" of that trading practice-the period of time between when given information would come to be incorporated into a stock's price with and without the given trading practice. The time horizon of the information on which an informed trade is based-the latency before it would otherwise be reflected in price-crucially determines both the strategies of those trading on it and the social value of such trading.8 Disaggregating traders and trading strategies in this way provides powerful new insights into how we can use regulation to deter socially undesirable forms of informed trading and promote socially desirable ones.

Essentially, the welfare case is strongest for promoting trading strategies where the prospect of profit generally induces robust information gathering activity and when the content of that information would not otherwise become reflected in public stock prices for a considerable period of time without that trading strategy. The case for permitting a strategy is weakest when the information-gathering incentives are weak and the information incorporated in price by the trading strategy would have rapidly become incorporated anyway.

The emphasis we place on counterfactual latency leads us to ask some questions that seem to have been neglected previously. For instance, what is the typical latency between when an insider transacts based on material nonpublic information and when that information would have definitively otherwise been incorporated in stock price due to a public disclosure. …

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