Market Manipulation and the Role of Insider Trading Regulations

Abstract

We model the impact of insider trading regulations on the dynamic trading strategies of corporate insiders. We focus our attention on Section 16(a) of the Securities and Exchange Act -- the trade disclosure rule. In a rational expectations equilibrium, we show that when an informed insider has to disclose her trades after they are made, she has an incentive to manipulate the market by sometimes trading in the "wrong" direction, i.e., buying with bad news or selling with good news. This strategy reduces the informativeness of her subsequent trade disclosure since a buy (sell) no longer unambiguously conveys good (bad) news and allows her to reap large profits in later periods by trading in the right direction. Such manipulation lowers initial bid-ask spreads and market efficiency and it can be curtailed by enforcing the short swing profit rule (Section 16(b) of the Act). The manipulation is more likely to occur when the market is liquid and when the insider's information advantage over the market is small. But it is less likely to occur when we allow for (i) the possibility of the insider being uninformed, (ii) the possibility of early arrival of public information, (iii) multiple insiders, and (iv) multiple trade sizes for the insider to choose from.

JEL Classification: G12, G15, G18, K22