News Release

Stock market of the future will have built-in safeguard against insider trading, study suggests

Peer-Reviewed Publication

Institute for Operations Research and the Management Sciences

LINTHICUM, MD, September 2 - Two professors modeling a stock exchange that uses electronic trading say the stock market of the future can have built-in characteristics that diminish the gains from insider trading, according to a study in a journal of the Institute for Operations Research and the Management Sciences (INFORMS).

The electronic stock exchange that they created for two sets of laboratory experiments levels the playing field by rapidly detecting and sharing insider information and imposing electronic penalties on insider traders. The researchers employed operations research techniques in their study.

"As more and more electronic stock markets come online, we are also gaining the ability to structure them with a number of innovative characteristics," explains Prof. James R. Marsden, University of Connecticut, home of the new Treibeck Electronic Commerce Initiative. "If we can develop an electronic market that facilitates effective reduction of complexity, that allows people to easily track trading activity as it occurs, then we can significantly diminish the benefits of insider trading. With the current advances in information technology, I think such a scenario will eventually be possible."

The study, "The Use of Information System Technology to Develop Tests on Insider Trading and Asymmetric Information," appears in the current issue of Management Science, an INFORMS publication. The authors are Dr. Marsden and Y. Alex Tung, University of Nevada Las Vegas.

The Study

The authors conducted their experiments in the MIS Research Lab of the Decision Science and Information Systems Department at the University of Kentucky, where they were previously affiliated.

The researchers designed a research shell - a computerized laboratory environment - to provide controls, monitoring of individual behavior, and accurate recording and tracking of individual participant activities and market outcomes.

Participants in the experiments included doctoral students with graduate degrees in business, engineering, and mathematics. A group of undergraduates majoring in finance and accounting also participated.

In the experiments, four groups of students were monitored as they traded securities. They recorded their transactions on an electronic screen that included such fields as private, insider information that was disclosed to certain subjects as part of the experiment; the penalty rate if caught doing insider trading; a history of personal transactions and stock prices for prior periods; fees; information on the price and number of stocks bought or sold; and composite indices.

Random subjects were given access to the insider information.

Settling a Debate

Addressing a debate about the effects of insider trading, the researchers say that the first set of experiments provides strong evidence that insiders earn significantly higher profits than the market average.

To eliminate this advantage, whenever electronic monitoring finds evidence of insider trading the researchers' system imposed automatic monetary penalties. A second set of experiments examined a different way to level the playing field. In these experiments, the research shows, the advantage enjoyed by insider traders was quickly dissipated when information was rapidly shared with outsiders using electronic communication. Outsiders perceived the insiders' trading activity and quickly began trading accordingly, removing the insider advantage.

Basis for Future Experimentation

These experiments do not address large, complex stock exchanges like the New York Stock Exchange, say the authors. The insurmountable barrier when dealing with major exchanges, they say, has been reducing their complexity. Now, however, it seems that high tech advances can simplify the markets of the future.

"The continuing rapid innovation on information technology makes possible tracking and analysis that are the equivalent of market simplification," says Prof. Marsden. "A few years down the line, we could see significant advances."

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The Institute for Operations Research and the Management Sciences (INFORMSR) is an international scientific society with 12,000 members, including Nobel Prize laureates, dedicated to applying scientific methods to help improve decision-making, management, and operations. Members of INFORMS work in business, government, and academia. They are represented in fields as diverse as airlines, health care, law enforcement, the military, the stock market, and telecommunications. The INFORMS website is at http://www.informs.org .


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