Insider trading, 21st century edition

Insider trading is a significant problem in financial markets. And I am not talking about the legal form of company executives buying or selling shares in their companies outside of blackout periods around earnings announcements, etc.

In 2021, Talis Putnins from the University of Technology in Sydney and his colleague Vinay Patel examined all illegal insider trading cases prosecuted in the US. Based on that data they developed an estimation method to detect signatures of illegal insider trading in US stocks. They estimated that illegal insider trading happens in one in five M&A deals and one in twenty earnings announcements. Or roughly four times more often than the number of prosecutions.

As you may have guessed, illegal insider trading becomes more likely when the information is more valuable, e.g. when the M&A deal is larger or the earnings surprise is bigger, when the stock is more liquid and when more people are involved in the deal, providing a larger pool of insiders.  

Now Putnins and his colleagues have published another study that looks at a novel way how insiders make illegal trades, namely through ETFs. We live in a world where ETFs are available for more and more niche sectors. At the same time, some sectors are very concentrated in a few very large stocks, which implies that the ETF is effectively dominated by one or two stocks.

Take for instance the VanEck Vectors Oil Services ETF. Schlumberger is the largest holding in that ETF with a weight of 20% and Halliburton is the second largest with a weight of 10%. Investing in this and similarly concentrated ETFs is effectively an investment in these stocks with a little bit of diversification added to the mix.

If you are an insider who wants to conceal illegal trading activity, then instead of buying the stocks directly or options on these stocks (both of which are routinely monitored by regulators and companies to detect illegal insider trading) you can just buy a related industry ETF and escape detection. In his new study, Putnins found that this seems to be happening. They estimate that about $2.75bn in insider trading may have been done through industry ETFs from 2009 to 2021. The sectors that seem particularly at risk for such stealth insider trading are healthcare and technology with more than $1bn in suspected trades each.

How can we stop this? Putnins’ research indicates that more staffing and better resourcing of regulators monitoring trades helps to identify and reduce illegal insider trading. But his newest results about ETFs indicate that we might need to change the definition of what constitutes insider trading to include other financial instruments than stocks, futures, and options.