EXCHANGE TRADING RULES, SURVEILLANCE AND INSIDER TRADING
Are rules and their enforcement effective at mitigating insider trading? A study shows that rules and surveillance together have the potential to mitigate the perpetration of market manipulation but also to exacerbate the profits from such manipulative activities. Insider trading can be facilitated by several forms of market manipulation that are not, strictly speaking, by themselves insider trading. For example, spoofing, which involves giving up priority, switches, and layering of bids/asks, can be used to assist insiders to hide in the crowd by creating market distortions that would render insider trading difficult to detect. Similarly, volume manipulation through churning and wash trades can likewise make the detection of insider trading difficult. Therefore, the ability of an exchange to mitigate insider trading activity and the profits that arise from such activities depends significantly on the overall rule structure of the exchange and its ability to detect manipulation through domestic and cross-market surveillance. Prior studies on insider trading neither consider the complementarities across different types of market manipulation rules, nor the differences in surveillance. A study by Professor Douglas Cumming, PhD candidate Feng Zhan, and Professor Mike Aitken, for the first time examine complementarities across different market manipulation rules, including but not limited to insider trading. The study considers recent changes in insider trading rules that resulted from European directives to explore time series variation in the structure of exchange trading rules pertinent to insider trading and market manipulation. These changes were mandated by the European Commission and were not enacted in response to market manipulation problems in any one country per se, thereby giving rise to a natural experiment with which to study the effectiveness of exchange trading rules. Furthermore, the study employs a unique surveillance data in relation to the suspected insider trading . Unlike previous studies, we study the extent and timing of enforcement by considering surveillance. Through the analysis of monthly data from 22 exchanges in 17 countries, including Australia, Canada, China, Germany, Hong Kong, India, Japan, Malaysia, New Zealand, Norway, Singapore, South Korea, Sweden, Switzerland, Taiwan, the United Kingdom (UK), and the United States (US) for the period January 2003 through June 2011, the study uncovers a non-trivial role for exchange trading rules and surveillance in mitigating the number of insider trading cases, but exacerbating the profits per case. In the most conservative estimates, a 1-standard-deviation improvement in trading rule specificity gives rise to a 23.43% reduction in the number of insider trading cases and a 53.17% increase in profits on average. Overall, the findings highlight complementarities across different trading rules and surveillance, and these complementarities are at least twice as important as stand-alone insider trading rules for predicting the frequency of insider trading cases; however, the complementarities are less economically important for predicting the trading value for surrounding the insider trading cases relative to stand-alone insider trading rules. This study is the first in its kind that examine the exchange trading rules that govern market conduct and relate these rules to insider trading. It extends our understanding of the effect of different yet complementary market manipulation rules and specific direct policy mechanisms directly relevant to insider trading.