A game theory model of regulatory response to insider trading

ABSTRACT

We develop a model which can help in explaining the evolving regulatory regime around insider trading. We form a simple sequential game-theoretical model of insider trading transactions and, utilizing Monte Carlo simulation to determine equilibrium, we show that costly investigations and low penalties incentivize traders to engage in illegal transactions. While the model helps to explain stiffer action by regulatory bodies, the question remains as to whether the elevated penalty levels are sufficient to prevent further insider trading.

KEYWORDS:

• Insider trading
• financial market regulation
• game theory model
• Securities and Exchange Commission (SEC)

JEL CLASSIFICATION:

• C70
• G18
• K20

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ See, for example, Henning (2014) http://nyti.ms/1qJeCkn

² The percentage of successful insider trading prosecutions has increased from 56% in 2003–2009 to 79.2% in 2010–2011, and the proportion of defendants sentenced to two or more years in prison is now 50% (from 26% previously).

³ Source: Select SEC and Market Data – Fiscal 2015.

⁴ Raj Rajaratnam was sentenced to 11 years in prison and fined $150 million as a result of this prosecution (http://www.bloomberg.com/news/articles/2011-05-11/rajaratnam-is-found-guilty-of-all-counts-in-galleon-insider-trading-trial), while SAC Capital Advisors plead guilty to insider trading charges and paid $1.2 billion in penalties (http://www.bloomberg.com/news/articles/2014-04-10/sac-judge-approves-record-insider-trading-accord-with-u-s).

⁵ Martyn Dodgson, a Deutsche Bank Managing Director, was found guilty of passing on inside information to a number of friends that he met at a ‘stag party’ – the group allegedly made $10.3 million trading on this information. (https://www.theguardian.com/business/2016/may/12/painstaking-investigation-deutsche-bank-insider-trading).

⁶ Steven Xiao pleaded guilty to more than 100 illegal trades while managing director of Hanlong Mining in 2011 (http://www.abc.net.au/news/2016-03-11/steven-xiao-sentenced-to-jail-for-insider-trading/7239820).

⁷ Germany only introduced insider-trading laws in 1994 and there is yet to be a case of any significance.

⁸ See Appendix for additional detail on the numerical strategy employed.