On August 17, 2021, the Securities and Exchange Commission (SEC) filed the first lawsuit charging insider trading in an economically related stock. A former employee of Medivation (MDVN, a mid-sized biopharmaceutical company) was charged for trading on confidential information about the acquisition of MDVN at a significant premium. However, unlike a typical case of insider trading, the former employee did not trade shares of MDVN. Instead, prior to the release of this price-sensitive information, the insider purchased short-term, out-of-the-money options in Incyte (INCY), a related mid-sized biopharmaceutical company.
This trading is alleged to have breached MDVN’s insider trading policy and generated more than $100,000 in trading profits. If found guilty, the insider faces a civil penalty and officer and director bar. Trading of economically related firms while in possession of material non-public information is termed shadow trading by Mehta et al. (2020).
In a recent study, we find that a new type of shadow trading is widespread – insiders trade exchange-traded funds (ETF), rather than the stock of the company, to profit from price-sensitive news. Our findings suggest that insider trading of this type is prevalent in financial markets. The study argues that regulators should broaden their surveillance activities as, to the best our knowledge, law enforcement agencies have yet to prosecute any cases of insider trading in ETFs.
Concealing Insider Trading Using ETFs
ETFs allow investors to invest in an underlying portfolio of assets (e.g., stocks, bonds and even cryptocurrencies), rather than buy each asset individually. The average net inflows into U.S.-listed equity ETFs have risen substantially, to approximately $30 billion per month in 2022. In the U.S. alone there are over 1,700 ETFs with combined assets under management in excess of $5 trillion.
There are several reasons why ETFs are appealing for insiders to trade on their private information. ETFs are cost-effective, allow individuals to undertake shadow trading and benefit from the stock price increases of the underlying companies, and are extremely liquid, which allows insiders to strategically trade.
A key challenge in identifying insider trading using abnormal trading volume in a large sample of ETFs is that some ETFs will by chance have abnormal volume prior to price-sensitive news. To overcome this challenge, we use a “bootstrapping” approach to measure the amount of shadow trading in ETFs that is beyond statistical chance.
Specifically, we compare the trading activity of ETFs that are the most popular for insiders to trade prior to merger and acquisition (M&A) announcements, with a control sample of other ETFs that reflect trading under normal conditions. Rather than focus on scheduled corporate announcements (e.g., earnings) that tend to prompt abnormal trading in anticipation of the announcement, we focus on M&A announcements as they provide a cleaner setting to measure the prevalence of insider trading in ETFs. Prior studies show that insider trading occurs before a substantial proportion of M&A announcements, because they result in significant increases in stock prices (e.g., Patel and Putniņš, 2022).
When and Where Is the Insider Trading in ETFs?
We find evidence of insider trading in ETFs prior to M&A announcements. For example, we observe economically meaningful and statistically significant increases in ETF volume in the five-days prior to the release of M&A news in 3-6 percent of same-industry ETFs that are likely to be traded by insiders. We estimate this shadow trading in ETFs amounts to at least $2.75 billion over the last 13 years. This is only the tip of the iceberg, as there is likely to be insider trading in ETFs around release of other types of material information as well.
The prevalence of shadow trading in ETFs more than doubled from $150 million per year to $360 million per year between 2009-2013 and 2014-2019, respectively. This increasing trend coincides with ETFs becoming an established investment vehicle and with increases in ETF liquidity.
Consistent with theories of rational crime, we find that insiders are more likely to shadow trade in ETFs when their potential profits significantly exceed the risk of being prosecuted and penalized by law enforcement agencies and market regulators.
Our analysis suggests shadow trading in ETFs is most prevalent in the health care and technology sectors, where it exceeds $2 billion during our sample period. These industries are associated with higher levels of secrecy, and target firms are associated with the largest increases in stock prices following acquisition bids. These characteristics of the industries give insiders a greater information advantage over other investors and therefore larger insider trading profits.
Insiders also are more likely to shadow trade in more liquid ETFs, allowing them to strategically hide the price impact of their trades.
Why Should We Care?
By quantifying and identifying a new type of insider trading, our findings may help guide and broaden enforcement efforts to reduce insider trading in ETFs and related securities and improve investor confidence in the fairness of financial markets. To the best of our knowledge, there has yet to be a prosecution relating to insider trading in ETFs. Our results suggest that current insider trading laws may need to be revised to aid enforcement.
This post comes to us from Elza Eglīte and Dans Štaermans at the Stockholm School of Economics Riga, and Vinay Patel and Tālis Putniņš at the University of Technology Sydney. It is based on their recent article, “Using ETFs to conceal insider trading,” available here.
