Operation 'Perfect Hedge' – the Criminalization of 'Greed'

As most of our readers are probably aware, the ongoing FBI investigations into insider trading at prominent hedge and mutual funds has just yielded another  batch of arrests and indictments. This seems to be still the same investigation  that ensnared the founder of Galleon, Raj Rajaratnam, a little while ago. Apparently the investigation has been going on for four years running.

One shudders to think about the resources the pursuit of actual crimes has been deprived of as a result. Merely looking at the FBI press conference, we can see that those overseeing the investigation are already quite a voluminous congregation. Considering the pomp and fanfare with which these arrests have been announced, you'd think we have been saved from an alien invasion or something of similar import.

Mind, the FBI did a good job, in the sense that it successfully enforced existing law. It is the law itself that is the problem.

We already discussed this in some detail in a past article: one major problem with the insider trading legislation is that it is fiendishly difficult to decide at what point exactly an informational advantage becomes 'criminal'.

As a hypothetical example,  let us say that someone works out a new neural network type algorithm that after some testing seems to be capable of predicting the daily movements of a certain stock with 95% accuracy (of course that is impossible, but bear with us). One would certainly have to conclude that this is 'material information'. Moreover, it is certainly also 'non-public' information. Will the inventor be free to profit from his algorithm, or is he committing a crime by not telling the whole world about it immediately?

This unrealistic and exaggerated example is only meant to serve as an illustration of the difficulty involved in determining what kind of information should or shouldn't be regarded as a bar to trading.  Obviously there is a lot of room for subjective interpretation here, which in turn is an open invitation to abuse (we are not saying that the case in question is an example for such abuse – we are merely stating that the door for abuse is wide open).

As it were, this particular problem is probably not relevant to the case at hand. In connection with these most recent indictments, the FBI seems to have a very solid case in terms of the insider trading laws, as the specific 'material non-public information' concerns foreknowledge of the quarterly earnings reports of a number of companies, on the basis of which the accused executed their trades. They also paid the insider forwarding the information to them a hefty bribe, so presumably it won't be easy for their lawyers to convince a jury of their innocence.

Such cases have proved to be an 'easy sell' in the past. Juries are generally quite eager to stick it to those rich Wall Street bastards who unfairly enhanced their already large compensation by means of 'unfair' informational advantages. It is generally assumed as a matter of course that these activities must be harming someone. It probably won't help the defendants' case if they  tell the jury that they paid for the information after all, so there naturally had be something in it for them.

If one looks at the public comments on such cases (in e.g. the comments sections of media reports on the internet), the public at large seems definitely of one mind in condemning insider trading. The only fresh aspect to these condemnations is that they are lately tempered by the recognition that the same laws that will probably bring these hedge fund traders behind bars for a great many years don't seem be applicable to congressmen. Politicians are privileged to trade on insider information as much as they like. That is of course indeed unfair, as it violates the principle of equality before the law.

Before we continue, let's have a look at the FBI's press conference:


It starts out with the declaration (paraphrasing) that what was nabbed was a 'tight-knit circle of greed', a conspiracy of 'professionals willing to traffic in illicit information' in order to obtain 'an illegal inside edge over ordinary law-abiding investors'.

One can imagine that the ordinary law-abiding investors are outraged to hear this. One must also conclude that the major crime here seems to be 'greed'.

It is also alleged that they 'degraded their markets and the first principle of 'ordered capitalism', that the markets be free and fair.'

We must admit this is the first time that we have heard our corporatist system described as 'ordered capitalism'. It's an interesting terminology. It would of course be great if our markets were truly 'free' – however, it appears to us that 'ordered capitalism' and 'free markets' should probably not be conflated. As to 'fairness' – if property rights are enforced and defended and all are equal before the law, we have all the 'fairness' we need. As an aside to this, modern-day politicians and bureaucrats have as a rule a rather more broad definition of the term 'fairness'. Whenever something is garnished with the adjective 'fair', it is usually a sign that one should hold on to one's wallet.

It appears from the great number of people nabbed in the investigation that 'insider trading activity has become rampant and routine' – if that is true, its advantages have probably become limited, but let's not digress. We are supposed to be 'disturbed'.


What Insiders Know and Don't Know

It is very interesting what the New York assistant director of the FBI, Janice Fedarcyk had to say.

Connected by friendship or business association, seven individuals (of the total 63 nabbed, for some reason only the seven are discussed), exploited material non-public information on the quarterly earnings reports of Dell and Ndivia before they were released.

As noted above, in this sense the case appears to be quite solid in terms of the existing law. The traders concerned also acted in a manner that reveals that they well knew that they were breaking the law (for instance, they arranged to make payment for the information they obtained in a manner designed to conceal it).  Convictions will likely be obtained.

But then Fedarcyk makes an assertion that is not only unprovable, but is in fact entirely wrong.

She says: “In essence they knew ahead of time in which direction the stocks of Dell and Nvidia would move once quarterly earnings figures were officially announced”. She then compares the situation with having an answer sheet beforehand, making it easy to 'pass the test'; alas, “cheating on the test and getting away with it are two different things.”

However, this is not a good comparison at all. In spite of having a significant informational advantage, these traders did still not possess a crystal ball.  What they did apparently know ahead of time were the earnings results. What they did definitely  not know is 'how the stocks of Dell and Nvidia would move'.

It is erroneous to assume that there is a simple, fixed and always valid cause-effect relationship between an 'earnings surprise' and the subsequent move in the stock concerned. There is no such thing. It depends on how much of the 'surprise' the market has already discounted beforehand, it may also depend on the general movement of the market on the day of the release, it may depend on whether market participants decide to focus on the 'miss' or the 'beat' or rather on some other aspect of the report. It is in fact unknowable in advance how a stock will react to the disclosure of certain specific information.

All that can be said in advance is that the probability of a certain reaction is enhanced, but there can be no certainty whatsoever. It is perfectly conceivable that someone trading on insider information of this type gets his head handed to him because he anticipated the market's reaction incorrectly.

As anyone involved in investment and trading knows, it happens with unwavering regularity that a stock tanks on 'good news' and rises on 'bad news'. The fact that the gentlemen in question were allegedly able to profit (or 'not lose') to the tune of $61 million is entirely irrelevant with regards to this incontestable fact.

The SEC's representative then goes on to claim that the activities of these traders 'pose a grave threat to the integrity of the markets'.


Who Is Harmed?

What remains unmentioned throughout the press conference – and this should be no surprise – is who exactly was harmed.

Now, to be clear about this: it seems obvious that the accused have broken the law. The question that needs to be considered is why there is such a law and who is helped or harmed by it.

From the standpoint of a publicly listed corporation itself, it may be regarded as undesirable if one of its employees forwards non-public information – of whatever type – to outsiders. A corporation can always include  a prohibition against such activities in its employment contracts. If someone is then found in breach of these contractual employment conditions, he can be sued for restitution in a civil suit. This would be beneficial to shareholders, whereas the criminal prosecution of such people yields exactly squat for shareholders,  while it is clearly detrimental to tax payers (the investigations are no doubt quite costly and the convicts must later be housed in prisons at great expense). As mentioned above, the resources deployed in pursuing these crimes are no longer available for other employments. What we see is that a bunch of illegal insider traders got caught. What we do not see is how many thieves and murderers were not caught because the resources to pursue them were lacking.

So the question then should be, if such insider traders are pursued at great cost to the tax paying public, what ends are actually served? Who was harmed by the activities of these traders?

The answer is: no-one. It is a victimless crime.

Consider in detail what happens when negative news are released that actually do have the effect of sinking a stock's price: from one moment to the next, all holders of the stock concerned will lose a chunk of money. Often when the news are released while the market is closed, the stock will open with a 'gap down' – no holder of the stock has a chance to escape the loss. It is instant and irrevocable.

Now let us consider that in the days leading up to the news release someone with inside information sells the stock concerned. Some may be inclined to argue that he defrauds those buying the stocks he sells. Alas, their decision to buy has been taken irrespective of the insider's selling: if he had not sold, they would have bought from someone else. On the contrary,  the insider's activity will not only not harm, but actually benefit such buyers, as the additional supply of stock on offer will lead to a lower price than would otherwise obtain.

Also, the insider's selling can not alter the fact that all stock holders will lose to the same extent after the news are released. The market's reassessment of the stock's value after the news release is an entirely independent process.

By hindering insiders to trade on their informational advantage, the market as a whole gets less information (in the form of price changes) than it otherwise would. As it were, there are always traders who 'know more' than others. It would be erroneous to assume that there is truly a 'level playing field' in terms of the information different traders possess. The level of knowledge as well as the ability to correctly appraise future conditions is not equally distributed among market participants.

The main complaint the insider trading legislation seems to address is that those in possession of non-public information are able to make a profit with ease. It is not a law that 'protects' the public or shields it from making losses or foregoing profits.

Its main aim seems to be to punish  the achievement of profits in what seems to be a ' too easy' manner. It certainly does not contribute to market efficiency, as it keeps non-public information from 'leaking out' into securities prices.


Addendum: Governments Hitting Out at the Rating Agencies

Governments are quite eager these days to punish the harshest of the credit rating agencies, Standard & Poors. Already the US government investigated S&P in what appeared to be a vindictive manner following its downgrade of US government debt last year.

Now it is Italy's turn to intimidate the rating agencies. As Reuters reports:


“Ratings agency Standard & Poors hit back at Italian prosecutors on Thursday after sources said its offices in Milan were visited by tax police pursuing a probe into the impact of S&P's reports on Italian share prices.

"S&P is surprised and dismayed by these investigations into our independent ratings," S&P said in a statement sent by email. "The claims being made are baseless and entirely without merit, and we will vigorously defend our actions, our reputation and that of our analysts."

A source close to S&P confirmed Italian tax police had carried out the visit but declined further comment. An investigative source said the move was part of a probe being carried out by prosecutors in the southern Italian town of Trani.

"I only know that it's part of the Trani investigations, but I don't know any more," S&P defence lawyer Giuseppe Fornari said on his way in to the S&P offices.

In August Italian prosecutors seized documents at S&P's offices in Milan following complaints from Italian consumer groups over the impact of its reports about Italy on Milan stock prices. One of the complaints filed in May last year targeted Standard & Poor's after it threatened to downgrade Italy's credit rating because of its huge public debt.

Prosecutors are investigating whether crimes of market manipulation and illicit use of privileged information were committed when S&P's reports were released in May, June and July 2011, prompting a sell-off of Italian assets.

Earlier this month S&P hit the euro zone with a downgrade of half the countries in the single currency area, including Italy, fuelling long-standing frustration with rating agencies. A day after the downgrades, a leading political ally of German Chancellor Angela Merkel urged legislation to reduce the reliance of institutional investors on ratings agencies.

Separately on Thursday, sources said tax police had carried out routine checks at S&P's Milan headquarters at the end of November, which had thrown up "interesting" findings, but added that Milan prosecutors had not opened an investigation.”


(emphasis added)

This is quite symptomatic for the way in which the European political and bureaucratic classes see the crisis: namely as a 'battle between markets and politics'. It is not their vast indebtedness and their profligacy with public funds that is at fault – it is held to be the fault of those pointing the situation out, be they rating agencies or speculators.




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8 Responses to “Is Capitalism in Danger From People Trading With an Informational Advantage?”

  • juergenwahl:

    Yes. People trading with an unfair advantage, over time, will collect all of the assets at risk. Unfortunately/fortunately those with the greatest capitalisation will have access to the maximum unfair advantage. Capitalism can provide the most optimal benefits to the majority under a narrow definition of constraints. When the constraints are exceeded, by means of unfair advantage, then Plutocracy arises. For example, in 1950, the top 2% of asset holders in the US owned 48% of the wealth. By 2003, the top 2% owned 84% of all wealth. I am certain that this %tage is much worse, today. Rule and unfair advantage, by and for the rich, is most certainly on the rise. Since I used to live in a Socialistic Workers’ Paradise (cynical statement), I can see alarming parallels between my prior experience and the present course of the US experiment. Those folks who are hoping for a burgeoning, Big Brother government to right all socioeconomic wrongs are in for a most discouraging endgame. Equality of opportunity – not outcome – makes for the most vibrant and equal-by-natural-law society. Unfair advantage will permit those who sincerely want to be rich to attain their wildest dreams – und heck to everyone else!

    • Jürgen,

      I would however say that we must differentiate here between various causes and effects. The great wealth disparity is mainly a problem because the incomes of the middle class have stagnated and even fallen while the rich got richer. This has a great many causes, but the chief cause is imo monetary inflation. I wrote an article on the topic not too long ago:
      ‘Wealth and Income Inequality in the US’ : http://www.acting-man.com/?p=8422
      Naturally I fully agree with your statement “Equality of opportunity – not outcome – makes for the most vibrant and equal-by-natural-law society”.

  • Belmont Boy:

    “…thieves and murderers…not caught because the resources to pursue them were lacking.”

    The resources applied here are not the sort the FBI employs to catch thieves (i.e. “common thieves”) and murderers. Rather, they involve the kind of expertise which can build cases against bankers who, for example, fraudulently packaged and peddled loans.

    In light of that, my hunch is that the feds are using insider trading prosecutions to look like they’re “doing something about financial crime.” They throw a few sleazeballs to the wolves, so as to appear effective. Meanwhile, the real big shot crooks, whose support politicians need in order to hold power, and who control the central bank, get a free pass.

    • I agree, this is the better comparison in terms of resource use, and I also agree with your interpretation. People are baying for blood, so there is now this big show of catching evil hedge fund operators, while many of the greatest criminals continue to roam free.

  • worldend666:

    Who is defrauded by the insider trading? Clearly the 61 million came form “someone’s else’s” pocket below.

    >>Some may be inclined to argue that he defrauds those buying the stocks he sells. Alas, their decision to buy has been taken irrespective of the insider’s selling: if he had not sold, they would have bought from someone else

    It is “someone else” who is defrauded here. Because the naughty boys at the bank sold first he is offered a lower price for his stock. The difference between the price he would have sold for and what he got is undoubtedly exactly 61 million dollars :)

    • I disagree – no-one is defrauded, because – as I explained – once e.g. bad news come to light, the losses concern ALL shareholders simultaneously and instantly. It matters not one whit who traded at the margin beforehand. On the contrary, by selling (in this case, where bad news are expected), the insiders increase the supply of stock at the margin prior to the dissemination of he news, and so actually lower the potential losses of the marginal buyers.

  • Specterx:

    I can see the libertarian argument to permit insider trading, but something about it nevertheless seems very ‘wrong’.

    I would not be so quick to dismiss the view that insider traders defraud other investors. Whether somebody ‘would have bought anyway’ seems irrelevant; there is clearly a difference as to whether a salesman sells you a product he _knows_ to be faulty, versus a faulty product which the salesman honestly believed to be in good working order, etc. Clearly things are more nuanced with stock speculation, but the point is the same.

    A similar case can be made for market-manipulation laws. One can argue that market manipulation is not possible in the long run, which is certainly true, but plenty of characters from Jesse Livermore to Jim Cramer have admitted to realizing significant profits from it. Clearly this sort of activity doesn’t further price discovery, as can be argued with regards to insider trading.

    In any event, the harm to capitalism from these activities seems real enough. When the market ceases to be a venue where savvy and diligent investors can reap the rewards of sound investments or speculations, and instead becomes simply a vehicle for the en-masse transfer of wealth from the general public to a tiny group (really almost a guild or cartel) of corporate insiders and pool operators, with whom there is no possible way to compete, it certainly looks to me like a danger to capitalism: people lose confidence in the securities markets and simply withhold their capital.

    Not that insider trading or anti-manipulation laws seem to actually prevent any of that these days, but still…

    • Evidently it is a highly controversial subject. The main problem from my point of view is the question whether trading on insider information should be subject to criminal law. I think public companies would have an interest to put a stop to it themselves, but this could be handled in civil law (via contracts with employees that are in positions where such information can be obtained).
      For those interested in reading more on the topic, here is an interesting article by Ostrowski (a securities law specialist) on the M. Stewart case: http://mises.org/daily/1032
      and here is Rothbard’s explanation as to why it is really a victimless crime:

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