Informed Trading

Informed trading involves the act of trading securities by individuals or entities who have access to material, non-public information (MNPI), which influences market efficiency and fairness.

We look into the essence, implications, and regulatory aspects of informed trading.

Key Takeaways – Informed Trading

• Asymmetric Information Advantage
  • Informed traders possess superior, often non-public, information about assets.
  • This gives them an edge in predicting market movements accurately.
• Market Impact and Profitability
  • Their trades, based on informed decisions, can impact market prices and trends, and potentially higher profits compared to traders without such info.
• Regulatory Scrutiny and Ethical Considerations
  • Informed trading, especially if it borders on insider trading, attracts regulatory scrutiny.
  • Traders/individuals/entities operating with genuine information advantage(s) must navigate ethical and legal boundaries carefully to avoid sanctions.

Essence of Informed Trading

Informed trading refers to transactions based on privileged information that isn’t available to the general public.

This privileged information can include:

• impending financial disclosures
• insider news on mergers and acquisitions
• changes in corporate leadership, among other information

The traders in possession of such information are often insiders or have acquired the information through extensive research or connections, which provides them with a competitive edge over other market participants.

Impact on Market Efficiency

The concept of informed trading is intertwined with the Efficient Market Hypothesis (EMH), which asserts that asset prices in financial markets fully incorporate all available information.

Informed traders, by acting on exclusive knowledge, help in the rapid adjustment of prices to reflect new information, thereby contributing to the efficiency of the market.

Their actions ensure that prices are a more accurate reflection of the true value of securities, which is fundamental to the allocation of resources in the capital markets.

Regulatory Considerations and Market Fairness

While informed trading can enhance market efficiency, it also raises concerns regarding market fairness and transparency.

The advantage that informed traders have over uninformed traders (those trading without access to privileged information) can lead to a disparity in trading success.

Regulatory bodies, therefore, maintain oversight over informed trading activities to curb illegal practices such as insider trading.

Even the appearance of informed trading can be damaging to market confidence.

It’s important for companies and individuals to handle material non-public information with extreme care.

Illegal Informed Trading vs. Legal Informed Trading

Insider trading involves trading based on material, non-public information in breach of a fiduciary duty, and is a punishable offense.

Conversely, legal informed trading occurs when individuals act on information that, although public, hasn’t yet been fully digested by the market.

The challenge for regulators lies in distinguishing between legal and illegal informed trading and ensuring that the market remains as close to a level playing field as possible.

Examples of Legal and Illegal Informed Trading

Legal Informed Trading:

• Company executives buying or selling their own company’s stock based on internal information they have as part of their job. This is legal but heavily regulated to ensure fairness (e.g., Rule 10b5-1).
• Market analysts or fund managers making trading decisions based on their extensive research and expert understanding of companies or sectors.

Illegal Informed Trading (Insider Trading):

• Someone obtains private information about a company through improper means (corporate leaks, hacking, etc.) and trades based on that information.
• A person who has been entrusted with confidential information (lawyers, board members, etc.) misuses it to make a profit.

Examples of Material Non-Public Information

• Upcoming mergers or acquisitions
• Surprise earnings results (positive or negative)
• New product launches or failures
• Regulatory changes
• Significant lawsuits

How Does Informed Trading Affect Markets in the Short-Term & Long-Term?

Short-Term Impact

Informed traders can gain a significant advantage and potentially harm regular traders/investors who don’t have the same information.

Long-Term Impact

Insider trading erodes public confidence in the fairness of markets.

If traders/investors believe that the game is rigged, they’ll be less likely to participate, which can harm market liquidity and efficiency.

Informed Trading/Insider Trading in Equity Markets vs. Currency (Forex) & Commodity Markets

Informed trading and insider trading are not confined solely to equity markets; these concepts also apply to bond, currency (forex) and commodity markets.

While the public’s association with insider trading primarily involves stocks, any financial market where material non-public information can provide an advantage is susceptible.

In bond, currency, and commodity markets, insider information might include:

• non-public knowledge of central bank actions
• government interventions
• major supply disruptions, or
• significant trade agreements

Regulatory bodies worldwide strive to monitor and enforce laws against insider trading across these markets to ensure fairness and transparency.

The underlying principle is the same: trading based on material, non-public information that gives an unfair advantage over other market participants is prohibited, regardless of the market.

Broader Definition of Securities

The term “securities” includes stocks, bonds, and other investment instruments like derivatives.

Currency and commodity contracts are often considered securities under the law.

Additional Considerations

• Subtlety – Insider trading in sovereign bonds, currencies, or commodities may be harder to detect than in stock markets. This is due to the decentralized nature of these markets and the global factors influencing prices.
• Jurisdictional Challenges – Cross-border trades and varying regulations in the currency and commodities markets can create complexities for enforcement against insider trading.