Show business


Crisis weakened global financial hubs, and those eager to steal some of their business cleared their decks. Russia is no exception. As the economy starts to pick up, the seasoned idea of turning Moscow into a fully-fledged international centre - not only to handle deals from countries of the former Soviet Union, but also to catch up with Frankfurt, Dubai or Hong Kong – is coming back into fashion.

So far, however, even domestic businesses tend to set up companies abroad and raise capital on foreign markets. Urals Energy or X5 Retail Holding, essentially Russian companies with all their assets in Russia, are incorporated offshore and get their capital on the LSE. Rusal, an aluminium behemoth, has its shares traded in Hong Kong and Paris, not in Moscow.

The law on Russian Depositary Receipts (RDR), a proxy security that represents ownership in the shares of a foreign company, sought to encourage such semi-Russian companies to be listed on domestic exchanges. Alas, since January 2007 when the law came into effect, the RDR’s market is still to take off. At this rate, it will take a long time for the idea of an international financial centre to take shape.

‘Our task,’ said Russian Finance Minister Aleksey Kudrin in June, ‘is to create a complete legal foundation for any investor, Russian or international, within two or three years’. It will only be possible if the Kremlin adopts western laws and regulations as they are, word by word.

The law ‘On Insider Dealing and Market Manipulation’ of July 2 is a compilation of western legislation, especially of EU directives. Definitions and rules that follow, with some additions and peculiarities, familiar texts of the European parliament make up a nicely crafted and, by and large, useless document.


Is it in the nature of the stock market?

Despite numerous stories that naïve press routinely brings to light about those in positions of trust who misuse price-sensitive information for their own benefit, doubts remain as to why inside trading should be forbidden.

An immediate difficulty in justifying the anti-insiders laws is that it is not easy to identify the victims. On impersonal, anonymous stock exchanges a transaction that involves an insider is a coincidence in a row of similar deals. There is no inducement to trade with the other party or misrepresentation of facts that may be the case in a face-to-face transaction.

The harm to the outsider will occur regardless whether insiders have dealt or not, because the outsider would still have dealt with someone else on similar terms. The loss is not caused by the insider’s dealings. The thing that creates the loss is the initial lack of information and the following market readjustment when it becomes public.

It may seem, then, that the outsider’s real mistake was not in making a particular deal but in coming to the market where some people have more information than others.

This makes up the so-called ‘moral hazard’ problem - that the game itself is a con. ‘In our society, we traditionally abhor those who refuse to play by the rules, that is, the cheaters and the sneaks,’ states the American Bar Association's Report of the Task Force on the regulation of insider trading, ‘The spitball pitcher or card shark with an ace up his sleeve, may win the game but not our respect. And if we know such a person is in the game, chances are we won't play.’

Many economists, however, would disagree with the lawyers. The insider’s dealings may harm some players, they say, as in a takeover when one buys a substantial stock of a company, but most investors benefit.

It may seem then that the outsider’s real mistake was in coming to the market

In theory, the price of a share is simply the discounted value of dividends that will be paid on it in the future. So, the security’s current price must be nothing else but the collective opinion of investors as to what those dividends will be.

Yet it just does not work that way. When we buy shares we are not buying potential dividends so much as the right to sell those shares to someone else who will be more optimistic about the company’s prospects than we are. The price of securities reflects not what the average investor thinks about the company’s future but what the average investor thinks the average investor thinks about it.

In his famous book ‘The Wisdom of Crowds’ James Surowiecki, a writer and New Yorker columnist, argues that this line of reasoning is a sequence of inter-dependant decisions: when people figure out what a stock is worth, they do not value the company, but what others believe the stock is worth. They take their cues not from economics but from the crowd.

The stock price, therefore, can move significantly from its economic foundation. Though the market does eventually get prices right, in the meantime it creates bubbles.

It is diversity, the balance between what everyone knows and pieces of private information, that makes a difference between a mad crowd and smart investors. The combination of different pieces of knowledge, some right, some wrong, keeps the crowd wise. The more there are investors who refuse to buy just because all the others are buying, or vice versa, the better.

Evgeniy Dankevich: 'Regulators should worry less about insiders, and more about abusers'

‘Market without inside is impossible,’ says Evgeniy Dankevich, CEO of OTKRITIE Brokerage house in Moscow. ‘Let us imagine a market where all information is distributed equally and simultaneously to everyone. When an accident happens in a well belonging to an oil company, its shares would plunge from, say, $10 to $5 in a matter of seconds. This would be a catastrophe.’ If, he argues, there was inside trading, the change would be smoother and the market would have time to adjust to new information and act rationally.

Insider trading is not just a damper in the way of an approaching crash. It prevents new bubbles from arising, believes Professor Boudreaux at George Mason University.

‘Insiders buying and selling stocks based on their knowledge play a critical role in keeping the prices honest,’ says Donald Boudreaux, ‘Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie. And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large.’

When insiders trade on their non-public information, they cause asset prices to reflect that information sooner than otherwise and therefore prompt other market participants to make better decisions.

According to Henry Manne, Dean Emeritus at George Mason University School of Law, corporate scandals such as Enron and Global Crossing would occur much less frequently and impose fewer costs if the government didn't prohibit insider trading: ‘I don't think the scandals would ever have erupted if we had allowed insider trading because there would be plenty of people in those companies who would know exactly what was going on, and who couldn't resist the temptation to get rich by trading on the information, and the stock market would have reflected those problems months and months earlier than they did under this cockamamie regulatory system we have.’

Still, isn’t inside trading just a form of cheating? This ‘moral hazard’ problem is more psychological than real. Our society is based, at least partially, on exploitation of people’s self-interest, and not on their altruism. So why make an exception for insider trading? It is just another cost society has to pay, says Evgeniy Dankevich.


A big show

In a classical, yet somewhat legendary, example of insider dealing a top manager discovers that his company’s profit forecasts are about to be revised. Before revealing this information, he goes to the stock market and buys or sells, as the case maybe, the company’s shares.

In the real life, few insiders risk their position by acting in such an unsophisticated and blatant manner. When they do, it is an oddness caused by exceptional circumstances, dire needs or an attack of stupidity. The amount of money involved is relatively small; they cannot, typically, raise substantial sums quickly enough to be able to trade on their knowledge.

Those engaged in insider dealing on a regular basis are more delicate in their means; they use nominees, offshore structures - or just sell the information. Russian law ‘On Insider Dealing and Market Manipulation’, therefore, seeks to prosecute not only those who are directly associated with the company through employment or professional relationship, the so-called primary insiders, but anyone who may intentionally or incidentally become aware of price-sensitive information.

Yet, despite this, the odds of an insider being caught are, statistically, slim. Even in countries with developed anti-insiders legislation only relatively innocent and comparatively stupid get into trouble, and convictions are few and far between. Prosecution fails for many reasons, one being the difficulty of proving to the high standards of criminal law the set of facts (the proof of the requisite state of mind is particularly onerous) that constitute the offence.

The European Directive 2003/6/EC ‘On Insider Dealing and Market Manipulation (Market Abuse)’, from which the Russian law is copy-pasted, seeks to deal with the problem by moving away from the concept of ‘fiduciary duty’, a relationship between an insider and the company, to the idea of the ‘fraud on the market’, when the market as a whole is deemed to be harmed.

Anti-insider laws may undermine what really matters: the battle against market manipulation.

An improvement in theory, the development hasn't shown up in the numbers of successful prosecutions. The only visible result is that the link between an inside source and the market becomes more twisted than ever. Investors suffer from the drawbacks of inside dealings but cannot utilise its potential benefits, because the signal the insiders are sending is getting blurred in the way.

Anti-insider laws, then, may undermine what really matters: the battle against market abuse. Though lawyers and economists argue about the pros and cons of insider dealing, there is no debate about the immense damage various manipulative practices bring to the market. Yet, the very concept of market manipulation remains vague and matches the ‘he knows it when he sees it’ definition used by US Supreme Court Judge Potter Stewart.

If Russia wants to be quick in adopting new legislation, it has no choice but to bring in Western ideas. The one adopted today is simple: though we are not sure how insider trading really affects the market, the public must see that it is not tolerated, even if all efforts to stop it are largely in vain.


text: J. Vermin
picture: sabine voigt -



Do we really need anti-insider legislation?