In countries with weak law enforcement, what other market forces can help curb insider trading?
A new working paper found the presence of foreign institutional investors can significantly reduce insider trading profitability, beyond the effect of domestic institutional ownership.
This hypothesis is based on the reasoning that foreign institutional investors tend to come from home countries with better laws and regulations. As well, previous research found foreign institutional investors tend to promote better governance and social norms in destination countries, says Weikai Li, assistant professor at Singapore Management University and co-author of the paper.
Another explanation is that foreign investors may be more likely than domestic investors to intervene. “One reason is that foreign institutions usually do not have business relationships with a local company so they’re more likely to be independent and less likely to have conflict of interest to have to be loyal to the firm management,” says Li.
The effect of foreign institutional investors on insider trading is stronger in countries with weak insider trading regulations and poor institutional environments, the paper found. It’s also stronger when the foreign institutional investors are from common law countries instead of civil law countries.
The research outlined two channels with the potential to explain this effect — the information channel and the monitoring channel.
Li says the monitoring channel is more likely to explain the findings, while the information channel can be explained as the presence of foreign institutional investors improving the informational efficiency of stocks.
This is a passive reduction of insider trading activity, he says. “Foreign investors, for example, they may attract more media coverage if they invest in a foreign stock. And they also tend to attract more analyst coverage. Because more information becomes available when the firm is covered by more analysts or covered by more media, . . . there’s less scope for insiders to trade on private information.”
The monitoring channel is more active in nature, meaning institutional investors can monitor the illicit behaviour and take corrective actions.
“The second channel is . . . more related to the institutional investor directly monitoring the insider and using his voice or threatening to exit the position to try to reduce the insider’s incentive to trade on private information,” says Li. “. . . The monitoring channel directly reduces the incentive of insiders to exploit outside investors.”
The researchers used data looking at legal insider trading — the insider trading that regulators allow but require to be reported, Li says.
One example is a company only allowing trading after earnings announcements. “If more insider trading now happens after earnings announcement, that means that the company actually imposed some self-imposed regulation to reduce the insider trading activity.”
The paper also found that when foreign institutional ownership increases, there’s a shift in timing and more insiders start to trade after an earnings announcement than before an earnings announcement.
“That’s direct evidence that the foreign institutional investor actually shifts, or changes, the behaviour of the insider trading activity,” says Li. “So that’s where we find the strong evidence for the monitoring channel.”
The practical relevance of these findings is two-fold, he says. Firstly, foreign ownership can have a substitution effect for ineffective country-level law and regulation. “I think, from this point of view, the regulators in those developing countries probably should be more open and allow more foreign institutional investors in their country.”
From a practitioner perspective, says Li, those looking to trade on these insider trading signals can target countries with less foreign institutional investors because this is where the signals work best.
Li co-wrote the paper with Claire Yurong Hong, an assistant professor of finance at the Shanghai Advanced Institute of Finance, and Qifei Zhu, an assistant professor of banking and finance at Nanyang Technological University.
The paper was presented at the Northern Finance Association conference in Vancouver in September.