The Impact of Illegal Insider Trading in Dealer and Specialist Markets

Abstract

This paper provides direct evidence on the reaction of market makers to informed trading in both specialist and dealer markets. We examine the illegal trades of five stockbrokers who purchased securities based on stock-specific information obtained from advance, non-public copies of Business Weeks Inside Wall Street column. We find that these trades are associated with substantial pre-release volume and price increases, especially for Nasdaq stocks. Transactions based on this inside information yielded significant abnormal returns, provided stocks were promptly resold. Yet, in contrast to theoretical predictions, we find that both quoted and effective bid-ask spreads are unaffected by these informed trades. Instead, for both Nasdaq and Exchange listed stocks, market makers adjust the depth at the ask quotes. Ask depth falls once insider trading begins, then rebounds, generally above its initial level after it ends. We document that specialists decrease quoted depth relatively more than Nasdaq dealers, suggesting that specialist markets more readily detect informed trading. Overall, our results indicate that market makers use depth as the tool to manage asymmetric information risk during insider trading episodes.

Note: Formerly titled "An Analysis of Illegal Trading by Outsiders Based on Second-Hand Non-Public Information"

Keywords: Insider Trading, Depth, Business Week, Specialist, Dealer Market

JEL Classification: G12, G14, K22, D82