01.29.2014
By Terry Flanagan

Surveillance Rules May Exacerbate Crime: Study

Instances of market manipulation, insider trading, and broker-agency conflict are highly correlated with the trading rules of each stock exchange, along with surveillance to detect non-compliance with such rules.

More detailed exchange trading rules and surveillance over time and across markets significantly reduce the number of cases, but increase the profits per case, according to a research study.

The study, by Michael Aitken, head of Capital Markets CRC, an Australian think tank, and Douglas Cumming and Feng Zhan, professors at Toronto’s York University, examined exchange trading rules that govern market conduct and related these rules to insider trading.

The study employed surveillance data based on alerts, or computer algorithms, used by authorities to detect instances or patterns of market manipulation.

“The ability of an exchange to mitigate insider trading activity and profits from insider trading depend significantly on the overall rule structure of the exchange and the ability of the exchange to detect manipulation through domestic and cross-market surveillance,” the study said. “We uncover a role for exchange trading rules and surveillance in mitigating the number of insider trading cases, but exacerbating the profits per case.”

Insider trading, which generally refers to trading on material non-public information, is far from generic. Insider trading can be propagated through many different channels and brought about by different market participants, according to the study.

As a result, exchange trading rules regarding client precedence, front-running, trading ahead of research reports, separation of research and trading, broker ownership limits, restrictions on affiliation, restrictions on communications, investment company securities, and influencing or rewarding the employees of others could all potentially have an impact on the frequency and severity of insider trading.

The scope of exchange trading rules is precisely known by market participants, since they are prominent on each exchange’s webpage. The scope of surveillance, by contrast, is not precisely known, but can only be estimated by market participants. Rules and surveillance, therefore, have the potential to exacerbate crime.

“Rules and surveillance exacerbate the profits to insider trading, since would-be manipulators are likely to engage in insider trading only if the expected profits outweigh the expected costs, and the greater the number of rules and the broader the scope of surveillance the greater the expected costs,” the study concludes.

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