Inside regulator trading

While some people keep praising the virtues of regulation on anything and everything (see Izabella Kaminska here on Bitcoin), a brand new study seems to picture a slightly less rosy view of regulators…

(This research was originally pointed by Lars Christensen on his blog and Facebook account. Thank you again Lars)

The abstract is telling:

We use a new data set obtained via a Freedom of Information Act request to investigate the trading strategies of the employees of the Securities and Exchange Commission (SEC). We find that a hedge portfolio that goes long on SEC employees’ buys and short on SEC employees’ sells earns positive and economically significant abnormal returns of (i) about 4 % per year for all securities in general; and (ii) about 8.5% in U.S. common stocks in particular. The abnormal returns stem not from the buys but from the sale of stock ahead of a decline in stock prices. We find that at least some of these SEC employee trading profits are information based, as they tend to divest (i) in the run-up to SEC enforcement actions; and (ii) in the interim period between a corporate insider’s paper-based filing of the sale of restricted stock with the SEC and the appearance of the electronic record of such sale online on EDGAR. These results raise questions about potential rent seeking activities of the regulator’s employees.

Wait. Do you mean that Securities and Exchange Commission employees are humans like anybody else, driven by their own sense of greed? Amazing.

A few absolutely striking facts were listed in this paper. The SEC lacked a system to monitor employees’ trades until… 2009. Despite the system implemented early 2009, employees seem to be able to avoid large losses by selling their holdings just before a negative SEC decision is announced. Moreover, previous research also found that politicians and congressmen benefited from insider trading… A law was passed in… 2012 to prevent them from trading on privileged information. 2012! They must be kidding. How late is that?! The logic seems to be: impose red tape on corporations ASAP but please do not affect rent-seeking and other benefits of government officials! The effectiveness of the law still has to be researched…

For sure there are some limitations to this paper and its methodology: the authors only effectively analysed 7,200 transactions out of a total of 29,081. This is because many transactions had invalid tickers (some were mutual funds but… how is even this possible for other securities?), were not traded on American exchanges or had very limited data due to illiquidity. Moreover, they couldn’t identify individual employees and as a result worked on an aggregate portfolio. It is also fair to admit that the ‘abnormal return on short positions’ actually didn’t generate any profit but only prevented losses, as they were not short sales but outright ones.

Still, independently of our view of insider trading (many people argue that it isn’t such a bad thing after all), such results are significant and should be further researched. Regulators like to portray themselves as being on a moral high ground, shaming those guilty of insider trading and other frauds. So the news that they may well succumb to the same temptation as those vulgar and immoral capitalist insiders not only sounds very ironic but also reaches extreme levels of cynicism.

As Lars said:

Who is regulating the regulators?