Insider Trading in Derivatives Markets

Abstract

The prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) operate. Lenders use these instruments to trade the credit risk of the loans they extend. By design, CDS appear to subvert insider trading laws, insofar as lenders rely on what looks like insider information to transfer or externalize the risk of a loan to another institution. At the same time, the harm caused by using insider information in CDS markets can depart radically from the harms envisioned under existing case law. In the traditional account of insider trading, shareholders systematically lose against informed insiders. However, with CDS trading, shareholders of the debtor company can emerge as winners where this company enjoys access to cheaper credit and lower funding costs. A thorough re-thinking of traditional theory is thus required, as well as a more robust, theoretical account of the efficiency and welfare implications of insider trading in a world animated by complex derivatives markets. This Article shows that trading on insider information in CDS can improve at least the informational, if not also the allocative efficiency of financial markets in ways traditional accounts have scarcely anticipated. However, in doing so, CDS markets reveal that this informational gain can render markets "too" efficient where they impound new information selectively and with such force that market stability itself can suffer. Collectively, these observations suggest a need to revisit the insider trading prohibition itself – and to explore whether consistency can (and should) be brought to supervisory approaches in U.S. equity and derivatives markets.

Keywords: insider trading, insider, governance, corporate governance, debtor, creditor, banks, lender, hedge funds, activism, Securities and Exchange Commission, Rule 10b-5,Commodities and Futures Trading Commission, systemic risk, financial stability, O’Hagan, misappropriation, classical theory, Cady Roberts