Fishea And Robeb-The Impact Of Illegal Insider Trading In Dealer And Specialist Markets - Evidence From A Natural Experiment, stock

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Fishea And Robeb-The Impact Of Illegal Insider Trading In Dealer And Specialist Markets - Evidence From A Natural ...

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The impact of illegal insider trading in dealer and specialist markets:
Evidence from a natural experiment
✩
Raymond P.H. Fishe
a
, Michel A. Robe
b,*
a
School of Business Administration, U iversity of Miami, P.O. Box 248126, Coral Gables, FL 33124
b
Kogod School of Business, Amer
n
ican University, 4
400 Massachusetts Avenue N.W., Washington, DC 20016
December 2002
Abstract
f stockbrokers who
find that increases
price and volume occur after informed trades. During informed trading, market makers decrease
depth. Depth falls more on the NYSE and Amex than on the Nasdaq. Bid-ask spreads show
but not on the Nasdaq. We find none of these pre-release
changes in a nontraded control sample of stocks mentioned in the column. Our results show that
tra ing ha n important tool to manage
asymmetric information risk; and specialist markets are better at detecting information-based
trades.
increases on the NYSE and Amex,
insider
d
s a negative impact on market liquidi
ty; depth is a
JEL-Classificatio
n:
G12,
G14, K22, D82
Keywords:
Insider trading, Asymmetric information, Depth, Liquidity,
Specialist and dealer markets,
Business Week
ce in New York for
comments, the
ick, Ron Melicher,
versity of Auckland,
McGill University, the 2001 Meetings of the European Finance Association (Barcelona) and Financial Management
merican Law and Economics Association (Harvard), the 2002
Conference, and the 2002 Summer Meeting of the Econometric Society
(UCLA), for helpful comments. We are indebted to Tim McCormick for providing aggregate depth data for Nasdaq-
listed stocks. Michel Robe gratefully acknowledges the research support received as a Kogod Endowed Fellow.
Xinxin Wang provided excellent research assistance. This work began while Pat Fishe was a Visiting Academic
Scholar at the Securities and Exchange Commission. As a matter of policy, the Securities and Exchange
Commission disclaims responsibility for any private publication or statement by any of its employees. The views
expressed herein are those of the authors and do not necessarily reflect the views of the Commission or the authors’
colleagues on the staff of the Commission. We are responsible for all errors and omissions.
Association (Toronto), the 2002 Meeting of the A
Yale-Nasdaq-JFM Market Microstructure
* Corresponding author. Tel: 202-885-1880; fax: 202-885-1946
E-mail address:
mrobe@american.edu (M.A. Robe)
We examine insider trading in specialist and dealer markets, using the trades o
had advance copies of a stock analysis column in
Business Week
magazine. We
in
_______________________
✩
We thank officials at the Securities and Exchange Commission and the U.S. Attorney’s Offi
assistance with the study. In addition to an anonymous referee who provided very useful and detailed
authors thank Jim Angel, Henk Berkman, Graeme Camp, Jeff Harris, Kris Jacobs, Tim McCorm
Albert Minguet, David Reeb, Chuck Schnitzlein, and seminar participants at the NASD, the Uni
1.
Introduction
Many market participants believe that insider trading poses a threat to
the operation of
financial markets. However, this proposition is difficult to test because there ar
e few studies of
insider trading in which researchers can actually say they know for sure t
hat traders used
material, nonpublic information. Most studies rely on the position of a trader (e.g., company
official or board member) to infer access to, and use of, such information.
In this study, we examine data from a recent court case on insider tradi
ng that involved
116 publicly traded companies. Five stockbrokers acquired information on t
hese firms from
Business Week
’s “Inside Wall Street” (IWS) column, which they received th
e day before its
public release. Although not based directly on company news, trades based on prior knowledge
of the IWS column yielded abnormal returns. Because the brokers traded only
a third of the 116
stoc
ks, this episode offers a natural experiment on the impact of informed tra
ding in financial
markets. Also, because the stocks involved were listed on the NYSE, Amex and
Nasdaq, the data
yield the first comparison of the effects of illegal insider trading in dealer and sp
ecialist markets.
For all stocks traded by the stockbrokers and for most other IWS stocks, we have data on
transactions and quotes for three days around the insider trading day. Court records from the civil
and criminal cases identify the brokers’ trades within the transaction stream. By
aggregating the
trade and quote data in 15-minute intervals, we obtain a detailed picture of
market behavior
during and immediately following periods of insider trading activity.
We find strong evidence that illegal insider trading has a negative impact on market
liquidity. Our analysis shows that market makers adjust both depth and spreads
to manage the
risk presented by informed traders. Depth falls in both specialist and dealer markets, but spread
1
s
increase only in specialist markets. All these informed trades involve purchases, and we find that
only ask depth changes significantly. Relative to the average quoted depth on the previous day,
ask depth is 38% lower for NYSE and Amex stocks during insider intervals. After controlling for
1
Throughout the paper, we use the term “market makers” to refer to all liquidity providers, including specialists,
dealers and limit-order traders.
lower Nasdaq depth, ask depth for Nasdaq stocks falls by only 3% during i
nsider intervals.
2
These depth results are stronger when we exclude nine traded stocks featured
in non-
Business
Week
news stories before the insider trading period. The spread increases i
nvolve effective
spreads more than quoted spreads, with market makers in specialist markets provid
ing less price
improvement during insider trading intervals. Overall, specialist markets reduce depth and price
improvement more than dealer markets in response to insider trading.
We also examine how private information becomes impounded in stock
prices. Because
the IWS information was short-lived, these stockbrokers w
ere pressed to act on Thursday
afte
rnoon. Faced with this constraint, we find that they tended to single out sm
aller, less liquid
companies, which might have made their actions more detectable to others.
We find that Thursday trading volume is not unusual until the first inside
r trades. Though
buying pressures do develop once insiders start trading, we see significant
increases in the
number of trades and volume only after the brokers finish trading. The T
hursday volume
increase is large (almost two-thirds of the previous day’s total volume), but th
e brokers’ trades
only account for a small part of the increase. Court records show that the IWS information was
shared beyond the defendants, but trades by the brokers’ associates do not expla
in the additional
volume. The trades of all the individuals identified by the Securities and Excha
nge Commission
(SEC) with access to the IWS information make up no more than 9.2% of the
volume increase
for insider-traded stocks. We suggest that the increased buying reflects noi
se trading by either
“falsely informed” or mimicking and momentum traders. As defined by Cornell and Sirri (1992),
falsely informed traders are those who “fail to recognize the extent of the inside information
reflected in the market price, and thus incorrectly believe that they have super
ior information.”
Such traders may greatly increase volume until the extent of their misinformation is revealed.
Overall, the buy-side activity is higher both during and after insider trading intervals, and
prices rise markedly across these intervals. However, consistent with the mimicking or
2
For Nasdaq stocks, we aggregate ask (
bid
) depth quotes across all market makers quoting the best ask (
bid
) price.
By doing so, we ensure that our depth figures are comparable for Nasdaq- and exchange-listed stocks.
- 2 -
momentum view, prices do not increase enough that all of the information in the IWS column is
refl
ected in the Thursday closing price, because abnormal returns are also observ
ed on Friday.
Unlike other studies of insider trading, we have data on stocks for
which nonpublic
information was available to the five brokers but they took no action. These stoc
ks form an ideal
control group to determine whether the observed liquidity and price effects are really a
consequence of insider trades. After removing stocks for which there are o
ther information
events, we find no effects like those observed for the traded st
ocks. Depth and spreads do not
cha
nge; volume is normal; and there is no significant price appreciation, on Thu
rsday afternoon.
Thus, it appears as if no information has leaked to the market for these stocks.
To isolate the effects of these insiders’ trades, we develop an additional control sample
based on order flow imbalances. Chordia, Roll, and Subrahmanyam (2002) find
that signed order
imbalances affect bid-ask spreads and returns. Thus, it is possible that the respo
nses we observe
are due partly to market makers’ reacting to order imbalances rather than to infor
med order flow.
Our control sample uses the same set of
Business Week
stocks, but in the six mo
nths before these
brokers began trading. We match stocks to order imbalances observed on the day of informed
trading. After re-estimating the models with the control sa
mple, we use these regression
esti
mates to net out the effects of order imbalances from the data in the informed trading period.
Regressions using these adjusted data show depth and spread adjustments d
uring informed
trading periods, though spreads increase significantly only for exchange-list
ed securities. In
general, order imbalances are not responsible for our adverse liquidity results.
The data also allow us to examine the informed traders’ exit strategies. The returns from
trading on IWS information are short-lived. Therefore, stocks must be prom
ptly resold for
informed trades to yield abnormal returns. We find that these brokers were slow to adjust their
exit strategies and close their positions the next day. They learned this rule eventually, as their
holding period consistently decreased during the sample period.
The paper proceeds as follows. Section 2 discusses related theoretical and empirical
studies. Section 3 describes the data and offers graphical evidence on the impact of insider
- 3 -
trading. Section 4 analyzes abnormal returns to insider trading on IWS stocks.
Section 5
develops the statistical analysis of trades, spreads and depth. Section 6 concludes.
2.
Related literature
Most theoretical models of market making focus on the bid-ask spread as the tool used to
react to informed trading (e.g., Glosten and Milgrom, 1985; Glosten, 1989; Eas
ley and O’Hara,
1992; Madhavan, 2000). Recent models by Kavajecz (1998) and Dupont (200
0) examine how
specialist market makers can optimally change both quoted depth and spreads
during informed
trading periods. Kavajecz forecasts that depth will fall and spreads widen when
adverse selection
increases. Dupont, who also considers quantities and prices, provides predictions closest to our
results. He models the trade-off between unprofitable trades with informed traders and profitable
trades with liquidity traders. A higher spread or lower depth reduces losses to
insiders, but also
reduces liquidity trading because uninformed traders are price sensitive. Info
rmed trades are
distinguished in his model when the information signal is more
precise, which causes larger-size
orders.
Dupont demonstrates that these larger orders cause quoted depth to react proportionally
more than bid-ask spreads to informed trading. Therefore, in empirical research, depth changes
are more likely to be observable than spread changes during informed trading.
The ability to detect spread and depth changes depends on the nature o
f the information
event. Empirical research establishes that expected events, such as earnings
announcements,
affect both spreads and depth. In contrast, relatively little is known about how spreads or depth
3
react to unexpected events, such as those created by informed traders. The sole evidence to date
comes from Meulbroek’s (1992) analysis of SEC files on insider trading between 1980 and 1989,
and from case studies by Cornell and Sirri (1992) and Chakravarty and McConnell (1997, 1999)
of two NYSE stocks targeted by corporate insiders in the 1980s.
3
Liquidity falls just before and immediately following announcements regarding earnings (e.g., Lee, Mucklow, and
Ready, 1993; Kavajecz, 1999), dividends (Koski and Michaely, 2000), and takeovers (Foster and Vishwanathan,
1994; Jennings, 1994). See Kim and Verrecchia (1994) and Krinsky and Lee (1996) for discussions of earlier
empirical studies analyzing spread behavior around such expected information events.
- 4 -
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