How Insider Trading Affects Financial Markets?

We have already studied that financial markets and, in particular, securities markets are the backbone of any economy. It is, therefore, in the best interest of the government to ensure that investor confidence in financial markets does not decrease. A fall in investor confidence immediately becomes visible since it leads to a fall in the inflow of capital to the country.

In this article, we will explain what insider trading is, how it affects the financial markets, and what its other impacts are:

What is Insider Trading?

Before we begin to define insider trading, it is important for us first to define who an insider is. An insider is any person who is privy to material information about the company before it becomes public. The information is said to be material when it can influence the prices of securities that are traded in public.

Hence, by extension, insider trading is the misuse of privileged insider information. The basic idea is that people who are within the company will always have an informational advantage over the general population. Hence, it is the responsibility of the government to ensure that these people are not allowed to use this information while trading. Insider trading is not limited to when an insider such as an employee or a manager of the firm trades shares on their own account. If these insiders leak insider information to third parties, then to it is considered to be insider trading.

Insider trading is a punishable crime all over the world. In most countries, people who indulge in insider trading have to face severe repercussions, including prison time. Severe penalties have been imposed because of insider trading is allowed to continue unabated, then the entire financial system will face negative consequences. Consider the fact that if people with insider information are allowed to trade on an equal footing, they will beat the average investor almost 100% of the time. Over a long period of time, investors will start viewing the markets as a money-losing proposition and hence will simply stop investing. Therefore, to ensure that investors continue investing, the government has to make the markets fair. Therefore, it can be said that it is the government’s job to ensure that every investor has an equal chance of making money in the market.

In some countries like China, the government was not taking this job seriously. This was because the government, the single political party, the banks, as well as the major companies were closely linked. Hence, when people in the financial services industry took part in a scam, the government was also a beneficiary. Hence, no action was taken against them. As a result, the country saw an exodus of investors and was forced to enact stricter laws in order to prevent insider trading and regain investor confidence.

Measures Taken by the Government to Curb Insider Trading

Individuals who are involved in insider trading almost certainly go to prison most of the time. However, there is a monetary impact on the organizations which harbor such individuals as well. This is done because of the belief that insider trading is more of a cultural phenomenon. The logic is that if the company had maintained strict internal controls, the job of the regulator would have become much easier as insider trading would have been reduced.

Some of the measures taken by the government against corporate interests have been listed down in this article.

• Warnings: Insider trading allegations are difficult to prove. The communication that happens between the accused parties is difficult to intercept and give evidence of. As a result, a lot of manpower and financial resources have to be infused into an insider trading investigation. In order to avoid the same, many times, regulators give formal warnings to companies who they suspect take part in insider trading. These warnings are intended to give a message to the company that they are now under the scanner and therefore, must stop their questionable activities. In many cases, warnings are enough to get the company to at least temporarily mend its ways.

• Reputational Impact: If warnings do not serve the purpose, then the regulator is forced to undertake a thorough investigation. Once they get sufficient proof, the investigators make it a point to publicize the name of the company involved as much as possible. This is done to create a reputational impact on the company in question. Reputation matters a great deal in financial markets. Hence, the news of a company being involved in some kind of scandal proves to be very expensive. This can be seen from the dwindling share prices of the affected companies. This reputational and the resultant financial impact is designed to create deterrence. The regulators hope that this deterrence will help lay the foundation for internal controls that prevent insider trading of any sort.

• Fines and Penalties: Lastly, once the case has been proved in court, the individuals responsible do get prison sentences. However, the organizations which harbored them are also made to pay fines and penalties. This is because these organizations also benefit from unethical profits, which are made using insider information. It would be wrong only to prosecute the individuals involved and leave the organization, which provided the resources for the entire expedition untouched.

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