Monday, March 28, 2011

The impossibility of policing "insider information"

The investigations surrounding the Galleon hedge fund insider-trading scandal has provided an opportunity to observe the backroom activities that often underpin the actions of financial market traders and analysts.

In particular, of interest to readers in India, have been the revelations (transcript here and podcast here) that the former Chairman of McKinsey, Mr Rajat Gupta, was constantly passing on critical insider information to Galleon founder Mr Raj Rajaratnam, about investment decisions of firms on whose Mr Gupta was serving. The SEC, as part of its largest insider trading investigations, have found evidence that Mr Gupta passed on information to Mr Rajaratnam immediately after Goldman Sachs board meetings he attended and Mr Rajratnam in turn made investments based on that information.

The investigations have thrown up several examples of such practices. Mr Anil Kumar, a McKinsey director, put his own reputation at risk, and passed insider information about Goldman's clients, in return for $2.6 m. Mr Rajiv Goel, an Intel Manager, has testified that he passed on advance information about the semiconductor group’s earnings to Mr Rajaratnam. There are surely more skeletons that will come tumbling down as the trial progresses.

It is inevitable that insider information on business dealings will be shared during socializing within a closed friendship network of financial market executives. Such information transfers can be either part of party gossip or deliberate leakages. It is inconceivable that atleast some of this information will not be used by some members of the group to make beneficial financial investments (directly or indirectly, through their partners). Since most of these executives are also investors in these markets, the incentive to profit from such opportunities are often irresistible.

In this context, Luigi Zingales points to a working paper by Andrea Frazzini, Christopher J. Malloy, and Lauren Cohen who find that college friendship ties generate a considerable premium. They find that portfolio managers place larger bets on firms that have directors who are their college mates, earning an excess 8% annual return. He writes,

"A benign interpretation of these results is that college mates know each other better; thus, a portfolio manager has an advantage in judging the quality of the CEO better if they spent time with him or her in college. But this benign interpretation is difficult to reconcile with the finding that these positive returns are concentrated around corporate news announcements."

In simple terms, it is almost impossible to police insider information sharing within small friendship networks and investment transactions based thereon. Criminalizing such information disclosure and moral suasion to encourage executives to keep such information confidential, while partially effective, have their limits. In fact, I would be surprised if insider trading were not rampant within corporate circles. The incentives are simply too attractive for atleast a substantial numbers of actors to forego. Only those with the strongest moral character can be relied upon to constantly resist the allurements from such information sharing.

Much the same conflicts of interest entangle government officials. They come from the same stock and faced with similar incentives are likely to react no differently. Consider this. Mr Babu Ram is the official who heads the Industries Development Corporation of Briberonia. The Government of Briberonia decides to set up an ambitious Special Economic Zone (SEZ) in about 100 Acres, about 25 km away from Metropolis, its capital city. Mr Babu Ram also heads the Committee that is to soon finalize the SEZ proposal.

Mr Realtor Ram is one of Mr Babu Ram's closest friends. During one of the regular family dinners, Mr Babu Ram mentions about the SEZ proposal. Mr Realtor Ram realizes the significance of this in terms of its potential impact on land values around the proposed SEZ location. He suggests that they buy a few acres at the prevailing cheap rates in anticipation of prices rising manifold once the SEZ is developed in a few years. Accordingly, Mr Babu Ram and his friends make considerable investments in the area.

One of the distinguishing features of the real estate bubbles in many Indian cities is the close nexus between politicians, bureaucrats, and real estate developers. Property developers have made rampant use of insider information to purchase massive extents of land adjacent to upcoming (and unannounced) mega industrial and infrastructure projects.

There is a slippery slope with such information disclosures and consequent actions. Such information is often used to dispossess poor people off their lands at very cheap prices and leave them laborers on their own lands. Further, once the regulators (the officials and politicians) have themselves invested in lands surrounding a project area, they develop a stake in the project itself, which often ends up distorting the government decisions on the project itself.

Such conflicts of interest are not confined to land issues. There is the likelihood that officials administering tenders on huge infrastructure and IT projects share confidential information (again, deliberately or as party gossip) on either the tender details or rival bidders within a friendship network. This could in turn unfairly favor some bidders, often in return for some benefits for the officials. A college friendship network involving an official and a potential bidder is amongst the commonest channel for such insider information transfers.

Just as in the financial markets, the service rules of government officials specifically prohibit such information disclosures. However, like in the financial markets, this has not prevented officials from working closely with private business interests and striking mutually beneficial relationships that have caused loss to the public exchequer.

In any case, I am inclined to the belief that, contrary to the optimism of Luigi Zingales that only a small proportion of traders are rotten apples, such unethical practices are more widespread in both corporate and government circles than we would like to believe. And as simple Econ 101 would teach us, higher the stakes, greater the incentives, and greater the possibility of prevalence of such trends.

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