By Jacob H. Kalphat-Losego
The Inside Trader’s Nightmare: Blockchain in the Public Securities Markets
Insider trading profits, or profits from the purchase or sale of a security by those in a fiduciary relationship with other holders of the security, have plagued United States regulators since the infancy of capital markets. While some commentators argue that the benefit from access to material, nonpublic information is just another way to compensate executives, others highlight that such a pay structure leaves public shareholders, and the market generally, to foot thebill. In fact, studies have found that when insiders trade on a firm’s nonpublic information they systematically divert value from the pockets of public shareholders, by some estimates to the tune of 5 billion dollars annually. Perhaps more troubling, though, are the costs for market efficiency. Insider trading profits depend in large part on the strategic retention and release of information to the public, which directly inhibits the ability of markets to accurately price securities. The possible payoff may even motivate the particularly brazen insider to try her hand at accounting gamesand other practices that artificially inflate share price.
While current regulation imposes a duty on insiders to “disclose or abstain” from trading and inflicts stiff penalties on those who violate securities laws, the Securities and Exchange Commission’s limitations in resources and manpower leave something to be desired when it comes to deterrence. Although the agency’s enforcement activity has curbed the incidence of insider trading in the lead up to certain “hallmark” corporate events (think mergers, tender offers, product releases), it is arguably the Securities and Exchange Act of 1934’s disclosure requirement which packs the greatest punch. By requiring the insider to detail and disclose all her trading activity within two business days, Section 16(a) of the Securities and Exchange Act of 1934 quickly alerts the public that insiders are on the move. In some cases, that siren is like a proxy for the nonpublic information beneath the insider’s trades—enabling outside investors to bargain accordingly.
Even so, more can be done. The implementation of blockchain technology in public securities markets would accelerate the market’s response to trading by insiders by making the details of those trades instantly available. Blockchain, which uses networks of computers to create a decentralized, tamper-proof “ledger” where individual transactions are received, authenticated, and permanently stored. These ledgers would allow the exchange to record and publish transactions in securities to outside investors in real time, bypassing the current need to wait on the SEC to receive, process, and distribute insider filings. While the degree of benefit would ultimately rely on the manner of implementation, blockchain remains a promising avenue for the public to efficiently and accurately price securities.
While encouraging, a bevy of questions are left open. For example, would the benefits of implementing blockchain in public securities markets outweigh the cost of implementation? Because any benefit would depend on the incremental advantage of instantaneous disclosure over the current two-day timeframe, the answer may lie in a comparison of the SEC’s current two-day rule and those of stricter regulatory regimes, such as Japan and the United Kingdom, which require same-day or next-day disclosure.