Ethical Finance And Sustainability

Published Date: 02 Nov 2017

Module Title: Ethical Finance and Sustainability

Banner Code: 07 25263

Lecturer: Dr Paul Fox

Assignment Title: Essay 1- Market Abuse

Word Account: 3242

ID number: 1272701

A Report Submitted to

MBA 2012/2013

Birmingham, United Kingdom

Table of Contents

Executive summary

The purpose of this essay is to study the current market abuse regime in the UK , identify the gaps and loopholes and propose suggestions for better enforcement of laws to FSA. We have first briefly introduced the past and current regulations in UK followed by stating the weaknesses of these regimes. The problems with getting catching the insider traders have been understood. The arguments have then been provided in relation to if these regimes are required at all? It has been discussed that how the prevalence of these market abuse regulations is actually distorting the market. Thus, the advantages of actually making the insider dealing legal have been clearly stated followed by the final argument.

Background: Market Abuse

The financial services market is a significant contributor to the United Kingdom’s economy. It employs a vast number and millions of investors who are dependent on the financial instruments and securities traded to create and maintain their pensions and savings. Moreover, as a sector it consists of pension funds, banks, stockbrokers and other trade institutions.

Even as the financial crisis (2009) has brought many illegal actions in the financial services industry in to picture, there has been a long history unlawful malpractices and behavior.

These malpractices can take various forms, where insider dealing has received greatest attention in both fictitious and real media. The costs, relevance and the outcomes of policing such activities or malpractices has become Market Abuse and this has been subject to debate for a long time.

The relevance, cost and outcome of policing Insider dealing and what has become known as Market Abuse have been subject to much debate.

Market Abuse

When a person in access of some private or an inside data conducts trades in the securities and financial instruments related to this information, it is known as insider dealing. When a person manipulates the financial instruments’ prices artificially by spreading misleading information, trades in these financial instruments in order to earn a profit, is known as Market Manipulation. These both practices, together is known as Market Abuse.

The UK Approach to Market Abuse Regulation

In the United Kingdom, UK FSMA Act 2000 (Financial Services and Markets Act) regulates market abuse and forbids investors to engage in market abuse. The FSMA section 118(2) states, behavior which leads to market abuse includes where "an insider deals or attempts to deal, in a qualifying investment or related investment on the basis of inside information relating to the investment in question." (www.legislation.gov.uk)

Source: (www.europa.eu)

The UK market abuse regime is based on EY MAD (Market Abuse Directive) and resultantly the market abuse rules throughout the Europe are now similar. In order to create some financial stability, the regulatory system has formulated some core principles through promoting capital adequacy, transparency for the corporations and to safeguard the interconnected payment systems worldwide. The following timeline depicts the regulations acts for Market abuse so far.(www.europa.eu)

The table I above shows the seven various types of market abuse as describes by FSMA.

Understanding Market Abuse Regulations on Timeline

Until the end second World War, the trading of securities and stocks in a firm on the grounds of information known to the company or its officers, directors or advisors only, was considered lawful worldwide.

1973- 1986

A joint statement issued the Stock Exchange and the Takeover Panel calling for criminal sanctions. Various subsequent trails to pass the legislation via Parliament were cancelled. In 1980 Companies Act 1980, Part V- sections 69-73 came into effect making insider dealing a criminal offence applicable under specified circumstances.

These provisions were later merged as Company Securities (Insider Dealing) Act 1985. This was late amended by the Financial Services Act 1986.

2000-

Financial Services Authority (FSA) was made the sole regulator by the Financial Services and Markets Act in 2000 and providing FSA the accordant authority to deal with the insider dealing and market abuse.

2005

Come 2005, MAD (the Market Abuse Directive) came into effect. This directive set out

the standards that everyone who uses the key financial markets in united kingdom should observe, if there are conducting a trade inside the UK or overseas. According to FSA, this code of market conduct helps to bring transparency in the market and makes everyone aware of the standards for dealing in the UK financial market.

2012-

The amendments in the MAD and proposal for MAD2 are scheduled to pass when approved by European council and parliament. However, it is expected that it would take about two more years before this regulation comes into effect and member states implement this new regulation fully.

Catching Insider Traders: A Big Problem

As said by an American Economist, Late Milton Friedman in the year 2003 (Fisher, 2009) - "You want more insiders dealing, not less. You want to give people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that."

"If you want to draft a law that is enormously difficult to prosecute, someone can

point at such a plethora of data as to why they purchased a share - pinpointing

insider knowledge is impossible." (Francis, 2010)

Given insider dealing’s nature where evidence is likely to be circumstantial in nature and even though a transaction can be tracked but it’s hard to prove the illegal actions of the people involved in the insider trading.

Moreover, the investors have access to so much data these days, for example press speculation, share price graph, personal research or even their own intuition, that it is very easy for them to elucidate their dealings on various reasons.

FSA loopholes:

"We also, currently at least, lack the ability to plea bargain which the Americans have used to great effect. This and the ability to enter into immunity agreements with witnesses in return for hard evidence, are areas which are under very active consideration as we believe the ability to gather sound evidence in this way may be a key to unlocking a number of difficulties, particularly in cases of systematic misuse of information by so-called "rings". Margaret Cole (FSA, 2007)

FSA clearly lacks the tools to tackle the insider trading fight given the fact that the investors are making use of the various financial instruments that has made the regulators job very hard and forces them to monitor the insider activities outside the stock market. Insider trader could use private contracts, options, futures derived from commodities, currencies, bonds , stocks that may be very difficult to track down. The complexity of market abuse and insider dealings would require the FSA to work together with police forces and other various crime agencies both nationally and internationally with other crime regulators. I am not completely criticizing FSA but what I am saying here is that the enforcement of these laws is very difficult given the enormity and complexity of the work required.

Making Insider Dealing Legal?

Although many agree on how insider trading results in a distorted market, but legalizing insider trading would benefit the market participants.

These arguments have been further explained as follows:

Information drives the market efficiency

If we comprehend the argument of Late Milton Friedman (www.telegraph.co.uk) - making insider dealing decrease the public awareness and leads to more of an underground behavior. Insider dealing could actually result in a more efficient and competent market. Moreover, it would reflect the share prices more accurately reflecting the individual share prices’ fundamentals effectively and a transparent open trading system would result in a better information sharing. This is same as suggested by (Fama, 1970) that rational investors make reasonable decisions. On the other hand, it can also be said that investors tend to under or over react following a herd outlook or perhaps there behavior could be more like an irrational exuberance.

Moreover, directing the information as soon as possible to the market will aid to decrease the asymmetry gaps and let the information flow to maximum number of investors. It would help to reduce bad information and smooth out volatility.

Now, in theory a share price will rise or fall and adjust to its equilibrium price according to the relevant information available. On the other hand, in case of ‘illegal’ insider trading- share prices usually explode as the investors rushing in order to exploit the information. Thus, insider trading results in a more efficient reaction to the financial information and by legalizing it, a share price would adopt a more gradual path to adjust to it appropriate value.

For instance, if an acquisition is supposed to happen, the share price would usually rise significantly on the day when the acquisition is announced. Now conceptually the acquisition does not take place overnight. If the insiders get on their hands on non public information and trade on it over the course of the acquisition, it would help to prevent the impulsive price jumps in the share price.

Charges don’t stick anyway:

Even if an investor is accused of insider trading it is hard to approve their involvement in the dealings. As (Francis, 2010) and Friedman suggest, it is very difficult for the authorities to establish an insider dealing case; moreover there have been various costly cases in which the prosecution has failed to do the justice to it. The lack of real evidence result in many cases being bunged by a settlement or probably the offender is found guilty of another charge. So the charges don’t stick anyway!

Other markets use Insider Information

Considering how real estate market functions with the help of insider information. If an investor thinks that the house is worth more than the price offered, he would buy it and the seller who wanted to sell anyway get his money. Now here the buyer probably acted on his own intuition or some inside information to make the deal.

‘Grey Area’ between inside information and an individual research:

Let’s consider a situation, a person sends out interns to a restaurant to talk to managers and to interview customers and count customer traffic so that these interns report back to that person about the sales trend on monthly basis, and technically this information is non-public and but has been concluded from a proprietary research. Trading on this research is legal.

Now, suppose this person dines with the CEO of the restaurant and he informs that person about the positive sales trend monthly before the CEO decides to put this information out publicly, it would still be illegal to trade on this information

So the methodology of deriving this information can make a difference?

Insider trading is a victimless crime

How can a crime be committed when there is no victim?

The person on another side of the trade would always have his own reasons to buy or sell, moreover, he would not even know the person on the opposite side of the transaction and would be affected by the insider transaction.

Insider trading is an economic plus.

The biggest reason for which the governments should allow insider trading is that it would do well for the economy. Insider trading helps the share price to reach their fully informed point as quickly as possible and this process is obviously delayed if insider trading remains a crime.

To the extent that the information capable of market alteration is held back from reaching the market, companies would not receive the amount of capital as they could. Insider trading could help poor or small companies gain much more capital than they could otherwise. But in the either case the capital is diverted, wasted and destroyed. The better alternative could be to encourage the information flowing which could ensure the efficient allocation of the investment.

Early Exposure of Frauds

Lastly but still a key point to this argument is that making insider dealing legal could help detect the frauds much earlier. For example- in the Enron case, many thousand investors were blazed as they piled up their stocks until the later stages of the fraud. Probably if the insiders would have been selling, the fraud would have been exposed much earlier.

Final Argument

My arguments, as stated above, focus on the legality of trading on the inside information. I would like to clarify that I do consider that people with the access to the information must morally and ethically respect their fiduciary duties and confidentiality agreements with the companies they are accessing the information from. And this would be a civil matter rather than a criminal matter.

I am not proposing that the insiders should be let off the hook as trading on inside information which is not legal currently, but I am suggesting that it is time that these regulations against insider dealing should be rubbed out. The market abuse rules are political, arbitrary and extremely inefficient. In short, the rules are in a mess and it is not only impossible to prosecute but the regulators and the governments are wasting countless pounds in their attempt to bring the criminals to the court. To think of it, can the real costs related to the market abuse regime be ever justified by intangible loss caused to the market integrity?

Obviously the laws and the regimes do not work effectively. Moreover, these laws work in favor these organized insiders, as the rest of the market is deprived off the crucial information the insiders get bigger turn for their inside information. Certainly, banning the insider trading is blocking the information flow. This would ensure the poorly priced market would surely repel instead of attracting the investors. Eventually, what investor needs is quality information to make informed decisions and criminalizing their pursuit of information which could result in a better pricing is not only leading to anti- capital formation but also retarding growth.

Thus, an unequal access to the information is creating an unlevel playing field that harms the faith in the stock market, where if the access to the information becomes equal, it will be more comfortable for the small investor to place their savings in the market.

In my opinion, there is no harm in trying to find information that can do good to the market and for the economy, but yes there is some problem with acquiring the information illegally.

I strongly suggest that the relevant laws for market abuse need to be reconsidered. Despite the costly efforts by FSA to keep insider trading at bay, there is sufficient evidence that insider dealing is still active and profits made from such trading are much excessive when compared to the average market returns.