The ETF revolution has opened up all sorts of new options for investors, including the ability to cover up illicit trades.
A new study suggests that financial wrongdoers have moved on to a novel form of insider trading, using exchange-traded funds to profit from information that has not yet been made public.
Conventionally, fraudsters with knowledge of a coming deal might buy a target company’s shares to secure a big payday when the news lands. By trading in a related security, like an ETF, insiders still may be able make some quick money while avoiding detection by regulators.
Looking at mergers and acquisitions announcements between 2009 and 2021, the study’s authors discovered at least US$2.75-billion in irregular trading prior to the deal being announced, while suggesting the true tally may be far higher. The study, entitled Using ETFs to Conceal Insider Trading, was written by researchers at the Stockholm School of Economics in Riga and the University of Technology Sydney.
While the analysis is limited to the U.S. market, few would be surprised if this were also happening in the Canadian stock market. ETFs have proliferated widely, while enforcement of insider trading laws is not especially stringent in Canada, at least compared with the United States.
“In racing, they say if you’re not cheating, you’re not trying,” said Robert Duncan, a portfolio manager at Forstrong Global Asset Management. “That shouldn’t be the case with investments. If you are trading material non-public information, you should be prosecuted.”
The problem is, insider trading, even in its traditional form, is hard to detect, and even harder to prosecute.
Last year, a total of five insider trading proceedings were concluded across the 13 separate provincial and territorial securities regulators, according to a Canadian Securities Administrators report. Fines and penalties of $683,000 were levied.
“There is probably quite a bit more insider trading going on than that,” said Andriy Shkilko, professor of finance and Canada Research Chair in Financial Markets at Wilfrid Laurier University in Waterloo, Ont.
An abundance of research supports that notion. Researchers in 2013 found evidence of unusual trading in the options market about 25 per cent of the time in the lead-up to transactions being announced in Canada and the U.S.
As for enforcement, a 2020 study estimated that only a fraction of insider trading activity in the U.S. is prosecuted – roughly 15 per cent. That number may be far lower in Canada, which has a reputation for being soft on financial crime. An analysis from 2006 showed U.S. authorities 20 times more likely to prosecute violations for insider trading than Canadian regulators, after accounting for the size discrepancy between the two stock markets.
Insider trading cases making headlines in Canada tend to be the more egregious examples. Last month, the Ontario Securities Commission handed down trading bans and about $5-million in fines and penalties against five men for illegal trades prior to acquisitions made by Amaya Gaming Group Inc. in 2014.
In that case, an analyst caught wind of Amaya’s impending acquisitions, including the parent company of PokerStars, and tipped off a co-worker, friend and an investment adviser, who then told several clients.
For those willing to trade on corporate secrets, there is a safer way – “shadow trading,” as coined by a 2020 paper. It examined trading prior to corporate announcements, but in “economically linked firms,” rather than the shares of the company making the news.
A major announcement by one firm can often have knock-on effects for the share prices of competitors and supply chain partners. Corporate insiders can sidestep trading restrictions by trading instead in correlated stocks benefitting from the development. The study found that the average shadow trade netted a gain of between US$139,000 and US$678,000.
Shadow trading in ETFs takes the manoeuvre a step further. A sector fund that includes the stock in question could very well see a substantial move when that company’s news hits the market.
“Our findings suggest insider trading is more pervasive than just the ‘direct’ forms that have been the focus of research and enforcement to date,” the researchers wrote.
But if the direct forms are difficult to police, this new version of insider trading may be next to impossible.
“Proving cause and effect gets really tricky,” said Rima Ramchandani, co-head of the capital markets practice at Torys LLP. An ETF with several different names has a lot of forces influencing its share price.
And yet, there is a good reason for regulators to want to control shadow trading. Traders acting on material non-public information profit at the expense of others.
“You want to make sure there’s information symmetry,” Ms. Ramchandani said. “Everyone should have access to the same information to ensure the integrity of the markets.”
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Tim Shufelt