Crypto Assets and Insider Trading Law’s Domain

Andrew Verstein is Associate Professor at Wake Forest University School of Law. This post is based on his recent article, forthcoming in the Iowa Law Review. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).

An extensive literature addresses the substance of insider trading law. For example, should new techniques of high frequency trading be penalized as a species of “insider trading 2.0?” Should all insider trading be decriminalized? Far less attention has been devoted to the domain of insider trading law. Insider trading law applies to stock, but does it cover bonds? How about commercial real estate, coveted artworks, or copper? Should it? The question of domain is distinct from the questions of whether we ought to have insider trading law at all or what precise form that law ought to take.

In a forthcoming article, I provide a limiting principle, which demarks the outer boundary of insider trading law. In building up the case for this principal, I carefully attend to an asset class that is commonly thought to lie beyond the domain of insider trading law and policy, and which are important in their own right: crypto assets, such as Bitcoin.

Crypto assets are new, but they are already outside the domain of insider trading law for most skeptics. American insider trading law regulates trading in material, non-public information. but many doubt the existence of material non-public information about open-source, virtual currencies. Likewise, American insider trading law generally requires the trader to have breached a duty of disclosure arising out of a relationship of trust or confidence but many crypto assets have no trusting “shareholders” or “executives” to trust. They are instead impersonal and decentralized, and “trustless.”

More foundationally, it is often argued that insider trading law does more harm to markets than good. The red tape of regulation and law enforcement could hinder innovation in this free-wheeling, open-source movement. Crypto assets require widespread adoption to become viable, and regulation can put a drag on such adoptions. Indeed, a central attraction of crypto assets for many users is that they work well even without state enforcement.

Crypto assets also exhibit innovative technological features that may obviate the need for familiar regulatory categories (such as securities regulation, the area most closely associated with insider trading regulation) or even render them counterproductive. For example crypto assets are subject to a radical check on market abuse: if users dislike a set of transactions, they are free to endorse a “fork” in the chain, which would undo the disputed transaction. They in effect abandon the current asset en masse in favor of a nearly identical replacement, which differs only in that it does not recognize the disputed transaction. Thus, when users of one crypto asset discovered a bug that allowed the theft of $60 million, they voted with their feet to abandon the old crypto asset and instead utilize a new asset—identical in every way except that it lacked the bug and the theft. This radical exit option has no analog in the world of securities, where the stock of a company retains its claims on the company’s assets even if the majority of shareholders were to dump the stock in protest over inside trading by company insiders.

Much of my article is a rejoinder to the current consensus on the domain of insider trading law. I argue that enforcement of insider trading law in crypto assets fits naturally with existing doctrine, policies, and priorities.

Insider trading doctrine clearly applies to most familiar crypto assets and their traders. The legal requisites for insider trading regulation—jurisdiction, material non-public information, breach of duty—are frequently conjoined. The most obvious examples of this concern misappropriation by employees of crypto asset trading venues about the venue’s plans to support a crypto asset; allegations of this sort of insider trading have already ended up in federal court. But there are many more examples, such as misappropriation by government officials and members of mining pools. Ultimately the question is not whether insider trading law applies to crypto assets; it is whether we want it to.

As a policy matter, the policies that justify insider trading law for other financial assets mostly apply to crypto assets: we care about fairness, price accuracy, property rights, and the rest. While crypto assets boast many features that could seem to make familiar regulations inapposite, in fact these features generate new and powerful avenues for insider trading. For example, while forking can solve some problems, it generates others. Those with foreknowledge of a fork, or a market intermediary’s reaction to the fork, know about a kind of material event with no easy analogue in existing insider trading cases literature. Nor is regulation inappropriate in light of the innovative nature of this nascent market or anarchic values driving many crypto enthusiasts. Regulation can be useful for taming the former while respecting the latter.

Although much of the article focuses on insider trading with a new asset, an examination of insider trading law and policy in crypto assets teaches us more than the right way to regulate crypto assets. Most importantly, a discussion of crypto assets gives us purchase on a general theory of the domain of insider trading law. There is a principle that links common stock and crypto assets, which are within the domain of insider trading law, but not commercial real estate and precious art and other assets which are clearly beyond the domain. A study in the domain’s borderland helps us to be thoughtful about the lines we draw and self-conscious of the reasons for drawing them.

Specifically, I apply a market microstructure framework to delineate the reach of insider trading law. Informed trading tends to increase price accuracy and decrease liquidity. Optimal insider trading policy is a function of those two effects: discouraging types of trading that decrease liquidity by more than they increase price accuracy. While both effects vary by type of informed trading, only liquidity effects vary greatly by asset class. Insider trading law’s domain includes those assets for which we expect informed trading to materially affect liquidity. That includes many high-volume, fungible assets such as stocks and crypto assets, but probably not office parks and paintings.

The complete article is available for download here.

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