Strategic Insider Trading and Its Consequences for Outsiders: Evidence From the Eighteenth Century

Motivation

Information asymmetry is inherent to trading and will always remain a threat to the fairness and integrity of financial markets. It is therefore important to understand how informed investors exploit their information advantage and how their strategic trading behavior affects uninformed investors. In our paper Strategic Insider Trading and its Consequences for Outsiders: Evidence from the Eighteenth Century, which is published in the Journal of Financial Economics, we answer these questions using unique hand-collected data from the early eighteenth-century London stock market. Because there were no legal restrictions on insider trading in this era, we can better identify the value of private information and the trading behavior of insiders.

 Historical Setting and Data

Trading in the early eighteenth-century London market typically took place in coffee houses close to the stock exchange. All share transactions were recorded by the transfer clerk in the company’s ledger and transfer books. Crucially, trading was not anonymous because both the buyer and seller had to be present in person in the company transfer office to sign the transfer book and exchange money from the buyer to the seller.

We retrieve all transactions from the ledger books and transfer files of three companies that comprised more than 40% of the market at the time: the Bank of England, East India Company, and Royal African Company. We observe the identity of every buyer and seller and various trader characteristics such as occupation and home address. We further collect information about the composition of the board of directors for each firm and classify each trader as either insider or outsider based on board membership. We also retrieve the minutes of all board meetings to obtain insight into the nature and materiality of the private information that board members had access to.

Value of Private Information

We quantify the value of private information by analyzing corporate events that were first discussed in board meetings and later published in newspapers. We find that directors buy unusually large amounts of shares before the publication of positive news and sell shares before negative news becomes public. We then show that this company news is followed by large stock price movements. The information asymmetry between insiders and outsiders leads to a large gap in their trading performance. Specifically, the post-trade returns of directors exceed those of other traders by 1.5% to 3% over a monthly and quarterly horizon, respectively. The outperformance of insiders is robust to the inclusion of fixed effects that control for unobserved trader characteristics such as IQ and financial literacy.

Strategic Insider Trading

The superior profitability of insiders’ trades raises the question why outsiders were willing to trade with insiders, given that trading was not anonymous in this market and board membership was public information. Our evidence indicates that directors camouflage their informed trades with the help of an intermediary who reverses her transaction with the director by trading with an outsider. For example, an insider can anonymize a sell transaction by selling stocks to an intermediary who then sells these stocks to an outsider. Although the outsider observes the identity of the intermediary, she does not know that the intermediary is unwinding a transaction with an insider. We show that the anonymized trades of directors earn significantly higher returns than their non-hidden trades, consistent with the prediction that insiders choose to strategically conceal their identity when trading on material and non-public information.

We also provide evidence that insiders strategically time their informed trades by trading more aggressively when a stock’s uninformed trading volume is higher. We document that the timed trades of directors are significantly more profitable than their trades on days with average uninformed volume, particularly over longer horizons. This finding is consistent with the prediction that insiders wait for better market liquidity when their information is long lived to minimize the price impact of their trades.

Consequences for Outsiders

In the last part of our analysis, we zoom in on the financial consequences of insider trading for outsiders. We quantify the expected loss for outsiders due to insider trading by multiplying the probability that an outsider trades with an insider by the average loss incurred from these trades. The average loss is measured as the difference in post-trade return between an outsider’s trades with an insider and her trades with another outsider. We find that outsiders’ expected losses from trading with a director range from two to seven basis points per transaction over a one-month and one-quarter period, respectively.

Because informed insider trades are typically more profitable than uninformed insider trades, we also separately estimate an outsider’s expected loss due to informed insider trading. We classify a trade as informed if it is strategically hidden and if the ex-post trade return exceeds a prespecified threshold. Using a threshold of zero, the expected loss for outsiders due to trading with informed directors is two basis points per transaction over the next month and four basis points over the next quarter. Expected losses are smaller at higher return thresholds because the increase in profitability of informed trades is more than offset by the decrease in likelihood of trading with an informed insider.

As a final step, we explore which outsiders are more prone to trade with insiders. We find that outsiders with more trading experience and a better understanding of financial markets are less likely to trade directly with directors. They are even more reluctant to trade with directors on days when directors are more likely to exploit their information advantage, such as board meeting days and days with high noise trading volume. However, we show that when directors strategically hide their identity by collaborating with an intermediary, both experienced and inexperienced outsiders can be harmed by informed insider trading.

Conclusion

Our study contributes to the understanding of market microstructure by providing novel insights about the trading behavior of insiders and its consequences for outsiders. By exploiting the unique features of our historical setting and the granularity of our data set, we provide strong empirical support for the prediction that insiders strategically hide their identity and time their trades to capitalize on their information advantage. We further document that this strategic insider trading is harmful to outsiders.