In February 2010, The New York Times reported that former Intel executive Rajiv Goel had testified in federal court that he provided inside information to Galleon Group hedge fund founder Raj Rajaratnam. The SEC and federal prosecutors described the Galleon scandal as the largest insider-trading case of its kind, charging 22 people with crimes after “Agents for the FBI secretly listened to numerous conversations Mr. Rajaratnam had with various sources of insider tips that resulted in over $50 million in gains for Galleon…”
High-profile cases involving Galleon, former Qwest International CEO Joe Nacchio, and Martha Stewart fuel public perceptions that insider trading is a rampant problem. But research conducted by finance professor Tao Shu, who recently won a Terry-Sanford Research Award, suggests otherwise. Shu and his colleagues, John M. Griffin and Selim Topaloglu, employed exhaustive research methods to look for evidence of insider trading, which they have chronicled in their paper, “Examining the Dark Side of Financial Markets: Who Trades Ahead of Major Announcements.”
“There’s always suspicion about whether institutional investors are violating regulations by misusing inside information,” says Shu, who says it’s human nature for the general public to wonder how Goldman Sachs can pay out an average employee bonus of $620,000 in recent years without misusing information. “However, there is a lack of a big picture — a comprehensive picture — in regards to the scale those institutional investors misuse information.”
Shu defines the misuse of information within the setting of institutions that normally have separate lines of business.
“They are not allowed to take information gained from one line of business and provide it to another,” says Shu, who uses the example of an investment-banking department underwriting an initial public offering and then providing the inside information obtained about that company to its trading department, which stands to profit.
In the past, academics searching for potential insider trades used a public database to analyze quarterly information from institutional investors. But according to Shu, that’s a far from perfect method. Activity generally occurs within a short window ahead of major events such as an IPO, a takeover, or an earnings announcement. Shu and his colleagues have access to a unique database where they collect their data directly from NASDAQ.
“We knew each trade of NASDAQ stock from a six-year period from 1997–2002. We looked at any short-term window during that period,” says Shu. He and his co-authors used that information to examine trades with price jumps of at least 20 percent or drops of at least 15 percent.
“Our findings provide a stark contrast to the conventional wisdom seen in news reports or many existing academic papers because all they tell you is that insider trading exists. We find that, in general, inside trading – or the illegal transfer of information – seems relatively rare.”
Shu, a 2009 winner of UGA’s Outstanding Teaching Award, says he and his colleagues are interpreting their results cautiously. Although one could conclude that institutional investors don’t, as a rule, conduct illegal trading or information transfer, he says it’s quite possible that they do – using methods that are too stealthy to detect regularly. “For example, if one institution gets inside information, but trades through a different, personal account, there’s no way to identify the informed trading unless we can establish a link between the two accounts.”
A former financial analyst at China Development Bank in Xiamen City, China, before he got his Ph.D. at the University of Texas, Shu says his desire to study ethical behaviors in financial markets sparked his interest in this type of research. “It is vital for all information in financial markets to be public. If a lot of people were making trades with inside information, no one would dare to trade – and the market will die. We need to make every effort to prevent this sort of trading.”