Information Asymmetry and Regulation
One of the most famous cases of insider trading in recent memory is that of Martha Stewart and ImClone. (https://www.sec.gov/news/press/2003-69.htm) Ms. Stewart's broker, Peter Bacanovic, is said to have warned his clients about the imminent failure of a key drug, Erbitux, to win FDA approval. It was a reasonable assumption that when this information became public, that the stock price of ImClone would fall. It is said that based on Mr. Bacanovic's advice, Ms. Stewart traded ahead of market, and therefore avoided significant losses.
There are two basic problems with insider trading. The first is a question of fairness. Should a person in-the-know be able to profit from information to which almost no-one else has access? The second problem is one of market efficiency. If insider trading is allowed to proliferate, markets become increasingly inefficient and investors lose trust in the markets.
So what is insider trading exactly? It is the use of "material, non-public" information to unfairly make gains or avoid losses. Information is material if it has the potential to impact the price of a security (usually stocks). The "non-public" part of the equation is a little more complex. Non-public information is, in its most basic form, data which is possessed by people in control of a company, the company's senior officers and a close circle of staff and consultants. Non-public information can be passed from one of the "insiders" in a limited fashion to select outsiders. As long as the information has not been made available to the general public, it is "inside" information regardless of who actually uses such information to avoid losses or make gains.
How does "information asymmetry" relate to "insider trading?" Information asymmetry is a legal term. In any business deal or transaction, Party A may know more than Party B. This may or may not be a problem. If we assume a transaction involves two corporations of similar size and resources, and no-one is deliberately withholding information, there is probably no moral hazard. If a transaction involves a large company with vast resources, and the counter party is an individual with limited resources, there is a strong possibility of a moral hazard for the corporation. The corporation cannot assume the individual has the capacity to close any information asymmetries. Insider trading is, by definition, an instance of information asymmetry because Party A (the person trading on information from inside a corporation) knows more than Party B (the general public) about the potential for gains or losses.
Does information asymmetry always hold the potential of a moral hazard? In our current financial regulatory system, the answer is almost always, "yes." What matters is our response to the moral hazard. Can insiders avoid the moral hazard and sell their own stocks? Yes. For example, insiders can avoid the moral hazard of trading on inside information through a scheduled series of sales of the security. These programmatic trades are not based on information, but are conducted on a regular basis, usually at a set amount, with the purpose of diversifying a portfolio. The inside trader avoids the moral hazard of trading on material, non-public information by trading according to a simple schedule.
The application of the theory of "information asymmetry" is not limited to insider trading. We can also see it at work in the DOL's proposed definition of "fiduciary."
A simple search on the DOL's "Fiduciary Investment Advice Regulatory Impact Analysis" (https://www.dol.gov/ebsa/pdf/conflictsofinterestria.pdf) for the proposed definition of "fiduciary" shows three uses of the term "asymmetries" and one hundred fifty five uses of the term "information." The references lead to a statement in the conclusion of the DOL's Regulatory Impact Analysis:
A wide body of economic evidence supports a finding that the impact of adviser conflicts of interest on retirement investment outcomes is large and negative. The supporting evidence includes, among other things, statistical analyses of investor results in conflicted investment channels, experimental studies, government reports documenting abuse, and economic theory on the dangers posed by conflicts of interest and by the asymmetries of information and expertise that characterize interactions between ordinary retirement investors and conflicted advisers.
In their analysis of the fiduciary definition, the DOL is drawing the following line:
- Current regulations, products and disclosure systems are complex and hard to understand
- The complexity of saving for retirement creates "information asymmetry" between the financial services industry experts and retirement investors
- A moral hazard arises when there are economic incentives for financial sales professionals to receive compensation which may or may not be entirely transparent to the retirement investor
- Fiduciaries are required to act in the "best interest" of their clients.
- "Best interest" is a term used as a synonym for "prudent." From the perspective of the DOL, there is sufficient case law and regulatory history for both industry and regulators to understand what is required to meet a "prudent person" standard.
- Because fiduciaries are required to act in the "best interest" of their clients, the DOL expects that the economic impact of conflicted transactions on investors will be reduced. A reduction in the impact of conflicted transactions on retirement investors equates to an almost dollar-for-dollar basis with improved investment performance. Why? Since fees are ultimately taken from a client's account, a reduction in fees is expected to produce a corresponding rise in investment performance.
When we understand the moral hazards regulators are attempting to control, the better we can respond to and address their concerns, and those of the investing and insured public. The moral hazard is a conflict of interest, i.e. compensation vs. the client, the DOL's proposed cure is a broad application of a requirement to act in the client's "best interest."
None of this analysis is intended to make a judgment about the DOL's proposal. Instead, it is merely an illustration of one of the theories informing the creation and application of modern regulation. There are other high level trends, such as "principles based regulation" which are also influencing the US regulatory system. Watch for these concepts to be explained in future posts.