What effect have insider trading regulations, including criminalisation, had on the NZX?
A fascinating research area that has emerged in the past decade or so is the interface between law and finance; more specifically, the impact of regulation on the overall functioning of capital markets. The enactment of a new set of laws is sometimes based on a post-mortem of an undesirable ex-post event, be it the collapse of finance companies in New Zealand or the occurrence of the Global Financial Crisis (GFC).
The new regulation is at times introduced on a rather ad-hoc and prevailing-sentiment basis, with little regard to academic and scientific research on the subject. Some suggest that the passing of financial regulation is the ‘result of psychological biases on the part of political participants– voters, politicians, bureaucrats and media commentators’. These biases could result in the enactment of laws that may lead to the deterioration of financial markets and the economy as a whole. Policy makers sometimes have to balance two conflicting concerns: the economic effectiveness of the law and socio-political views.
The introduction of a new financial regulation is deemed effective when it improves the overall quality and the working of financial markets by, among other things, increasing trading activities, lowering transaction costs and enhancing the dissemination of information to investors.
In a series of recent studies carried out by academics at the Department of Finance, we have investigated the market impact of two consecutive sets of insider trading regulation on various aspects of the New Zealand stock market.
The first one, introduced in 2002, was designed to address widely apparent deficiencies in the then prevailing system. Specifically, it tightened the disclosure requirements for managers and directors and replaced private enforcement by assigning the Securities Commission with the role of enforcer.
The second set of changes in insider regulation was enacted in 2008, the paramount feature of which was making insider trading a criminal offence.
We observe that the first change led to a significant improvement in the overall market quality (reducing the bid-ask spread, cost of capital, and information asymmetry; and improving the depth and liquidity). These changes were effective in reducing insider trading. The second enactment, however, was followed by a worsening in the above- mentioned measures, an indication that the criminalisation of insider trading may not have produced the desired market effects.
While the latter legislation may be desirable from a political point of view, the effectiveness of such legislation lies mainly in its deterrence effect, which is a combination of both the size of sanctions and, more importantly, its enforceability. Insider trading allegations are often based on circumstantial evidence; as such, the criminal burden of proof makes the enforcement of such laws rather thorny.
At the time criminal sanction was introduced, the Securities Commission had a dismal track record when it came to prosecuting illegal insiders. The introduction of criminal sanctions did not enhance public confidence in stronger enforcement. While a tougher stance against insider trading has become popular recently, there is little evidence that these laws are indeed effective. The Chairman of the Australian Securities and Investment Commission recently noted that despite recent successful criminal prosecutions there, the burden of proof and the evidence required remained challenging.
One of the roles of the newly-established Financial Markets Authority (FMA) is the stronger enforcement of the existing legislation. Unquestionably, since its establishment, a number of cases of non-disclosure or wrongful disclosure have been brought to court. It is crucial, however, for the FMA to be able to successfully prosecute insider trading cases in a criminal court. Such a successful prosecution could indicate a new direction. Altogether, it is the enforcement of law, not having dormant good law, that counts.
Alireza Tourani-Rad is head of finance at AUT. This article originally appeared in Engage magazine for AUT Business School