Insider Trading, Macroeconomic Risk and Network Theory

Abstract

A company insider possessing material nonpublic information can profit by trading in the stocks of her company. Moreover, since in an interconnected economy shocks propagate from one firm to another, she can also profit by trading in stocks of connected firms (e.g. suppliers and customers). In this article, I will show that these “network trades” create a moral hazard problem because they allow insiders to profit from risk-creation. In particular, by investing in a riskier project an insider produces larger fluctuations in the stock price of her company and of the connected firms. She can then use her privileged position to obtain early information on the direction of these fluctuations and then profit by engaging in network trades. Most importantly, the insights from network theory reveal that risk creation is more profitable for insiders that operate in industries that have a larger impact on macroeconomic risk, and hence network trades can play a key role in increasing the overall level of risk to which the economy is exposed. Given the severity of the 2007-2009 crisis, this insight offers a new and powerful rationale for regulating trades made by insiders on private material information. In particular, I advocate a reform divided in two steps: In a first phase, disclosure of network trades should be mandated to investigate whether they are a pervasive phenomenon and whether they produce abnormal returns for the insiders. In a second phase, if the data suggests that network trades are indeed pervasive and lead to abnormal profits, the following reforms should be implemented: (i) network trades on private material information should be banned, at least in the most central sectors; (ii) the rule requiring insiders to disgorge short-term profits when trading in the stocks of their corporation should also be extended to network trades.