In my paper, Insider Trading in the Derivatives Markets, recently made available on SSRN, I argue that the prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) trade. I demonstrate that the emergence of credit derivatives marks a profound development for the prohibition against insider trading, problematizing conventional theory and doctrine like never before. With the workability of current rules subject to question, this paper advocates for a rethinking of the present regulatory framework for one better suited to modern markets.
Lenders use CDS to trade the risk of the loans they make. And, when they engage in such trading, they are usually privy to vast reserves of confidential information on their borrowers. From a doctrinal perspective, CDS appear to subvert insider trading laws by their very design, insofar as lenders rely on what looks like insider information to transfer the risk of a loan to another institution. Fundamentally, insider trading rules prohibit trading based on information procured at an unfair advantage by those in a privileged relationship to a company. And, increasingly, insider trading laws are taking a fairly broad approach in preventing misuse of confidential information by those who acquire this information through their special access or through deception. For example, Rule 10b-5(2) can ground a claim for insider trading where someone trades on information obtained through a relationship of trust and confidence. In the CDS market, lenders usually buy and sell credit protection based, at least in part, on information they obtain in their relationship with the borrower, one ordinarily protected by restrictive confidentiality clauses. From the doctrinal viewpoint then, old laws and new CDS markets appear to exist in a state of serious tension. Put differently, either this thriving market is operating outside or at the margins of existing law—or the law itself has not adapted to the existence of these markets.
It is worth noting that finance theorists have long recognized that credit derivatives markets showcase an unmistakable tendency towards insider trading. This, they posit, can be seen in the uncanny ability of CDS markets to forecast events months and sometimes even years before they actually take place. Unsurprisingly, such prescience is especially likely for “negative” events that increase the chances of a debtor defaulting, that is to say, the kind of events that lenders care about and that drive lender decision-making about whether or not to purchase CDS protection.
From the theoretical perspective, the emergence of CDS markets inverts conventional theory underpinning the prohibition. Scholars have long argued that shareholders of a company systematically lose when its corporate insiders engage in insider trading vis-à-vis uninformed equity holders. CDS markets, however, profoundly challenge this theory. With respect to CDS, shareholders can emerge as winners by allowing lenders to use confidential information to trade CDS on company debt. Where lenders are able to hedge their risk using CDS, they may be more generous in extending credit to the borrower. In other words, by encouraging CDS trading on their company debt, shareholders can enjoy debt-driven growth, leaving creditors to internalize the down-side risk. This upside creates powerful incentives for shareholders to encourage lenders to use insider information to trade CDS on their company’s debt.
However, shareholders can also lose—and badly—through CDS trading on their company debt. Lenders can use insider information in a variety of ways—some of which may be far from beneficial for the company. Lenders might look for opportunities to extract private rents through their informational advantage at the expense of the company. For example, in the CDS market, lenders might increase their purchases of CDS protection, over-emphasizing their negative sentiment regarding the company. Such signaling can be damaging where it leads to negative spirals in the value of a company’s securities, making it harder for the company to raise money (and easier for it to default). One factor is especially significant in this regard. As noted earlier, the CDS market is highly efficient in processing negative lender sentiment regarding a company. However, this efficiency may become problematic where it leads to CDS markets impounding bad news with such force and speed as to destabilize trading in a debtor company’s other securities (e.g. shares and bonds).
These insights point to the need to re-conceptualize the doctrinal and theoretical bounds of the traditional prohibition. The operation of the CDS market—and the trading on insider information it can allow—shows that there are both costs and benefits to insider trading. As a starting point, the trade-offs suggest that insiders and investors might benefit from the ability to contract around the scope of insider trading liability. But, this solution is far from perfect. Such bargains depend on parity of negotiating position between insiders and company investors to be meaningful. In the case of CDS trading, such bargains may provide only weak protection for shareholders, given lenders generally enjoy considerable bargaining power vis-à-vis borrowers. This asymmetry makes it difficult for borrowers to make demands of lenders in how these lenders use the company’s confidential information. Importantly, current laws seek to bring derivatives markets in line with the insider trading regime applicable to equity markets, promoting consistency and symmetry across markets. However, it is worth exploring whether this symmetry can be better achieved by bringing equity markets more closely in alignment with derivatives markets, in other words, by relaxing the prohibition in equity markets. In questioning whether such symmetry between markets is possible (or even desirable), it becomes evident that thorough review and re-thinking of the prohibition is sorely needed to achieve meaningful reform in this area.
The full paper is available for download here.