A whispered aside in a bar, an indiscreet remark in an e-mail — this is the stuff on which inside trading thrives. But Blue Bottle, a Hong Kong firm fingered on February 26th by America’s markets watchdog, the Securities and Exchange Commission (SEC), showed more chutzpah. It netted $2.7m trading on information it had gathered by hacking directly into computers to view press releases before they were published.
This is not the most egregious insider-trading case of recent days. That accolade goes to a ring of 13 bankers and fund managers, including ex-employees of UBS, Bear Stearns and Morgan Stanley. Last week they were busted by the SEC for trading illicitly ahead of mergers and analysts’ stock-tips. What started as a ruse to repay a $25,000 debt allegedly spiralled into a lucrative scam as colourful as it was criminal. Mobile phones were binned to cover their tracks and cash passed around in Doritos packets. Some say the bust was the biggest blow against insider trading since Ivan Boesky was jailed and fined $100m.
That was 20 years ago. More recently, the SEC has lost its place in the vanguard of financial crime-fighting. In the rubble of the dotcom collapse, it was made to look flat-footed by Eliot Spitzer, then New York’s attorney-general and now its governor. Keen to regain the lead, Christopher Cox, the SEC’s chairman since 2005, has made fighting insider traders a priority. The commission must prevent any “buzz in the markets that you can get away with it,” says one of his officers, Walter Ricciardi. “Nothing paints a picture as well as people being led away in handcuffs.”
The SEC will act even when it has no one to put the cuffs on. Last week it filed a suit against unknown investors who had profited in the options market before the announcement of a takeover of TXU, the Texan utility. Over $5m of profits from these options has been frozen while investigators try to identify who bought them.
Insider trading is hard to quantify, but regulators see evidence that it is alarmingly common. The boom in mergers has provided more scope to make a dishonest buck ahead of deals. In Britain almost a quarter of takeover announcements in 2005 were preceded by suspicious price movements, according to the Financial Services Authority, the country’s markets regulator. In America, reports of suspect trading patterns filed by the New York Stock Exchange to the SEC have doubled in the past two years.
It is not just the stockmarket. Someone, for example, was busy buying protection against default ahead of the takeovers of HCA, a hospital chain, and Harrah’s, a casino operator. Trade volumes in such contracts can increase five- or tenfold in the days before a deal’s announcement.
Banks have responded by tightening internal checks on wrongdoing. But these are only as good as the people who apply them. One of the 13 busted ring-members worked as a compliance officer at Morgan Stanley. It was “like the head of the CIA turning over secret info to Osama bin Laden,” as a pundit put it.
Banks’ dealings with hedge funds are also coming under scrutiny. Hedge funds were big beneficiaries in the Morgan Stanley case and last September Linda Thomsen, the SEC’s enforcement head, singled out insider trading by hedge funds as a particular threat. Mutual funds have long complained that Wall Street brokers give advance warning of big “block trades” to their favourite clients; and the apples of the brokers’ eyes are increasingly hedge funds. As Roy Smith, a former Goldman Sachs partner, points out, these funds do vast amounts of trading, providing plenty of camouflage for illegal activity.
Others think hedge funds are a scapegoat. And a few, including the late Milton Friedman, a Nobel laureate in economics, think there is no sin to scape. He argued that insider trading should be legal, because it benefits all investors by quickly introducing new information to the market. Why should everyone have to wait for a company’s press release?
This is not, of course, the defence the hedge funds themselves are making. Some are tightening restrictions on outside contacts, others hiring compliance officers, all in the hope of heading off fresh calls for regulation. A Treasury-led group recently said none was needed but congressional leaders, due to hold hearings next month, may think otherwise.
But as Friedman might have pointed out, the issue of insider trading is riddled with grey areas. At what stage, for instance, does sounding out interest among institutional clients for an upcoming corporate financing become something sinister?
These fine lines are one reason why cases against insider trading are so hard to build. It is rare to find a smoking gun. The SEC and others use algorithmic programs to catch unusual peaks and valleys in trading. Though cutting-edge, the maths takes them only so far. Proving intent, says Mr Ricciardi, requires plenty of “good old-fashioned detective work.”
Even the most brazen malfeasance can be hard to turn into a watertight prosecution. Eyebrows were raised in 2005, for instance, when a retired Croatian seamstress bagged over $2m from a series of sophisticated options trades in advance of Reebok’s takeover by Adidas-Salomon. But building a case against the conspirators, led by a Merrill Lynch analyst, took many months of painstaking work, sifting through thousands of e-mails, brokers’ statements and telephone records.
No doubt uncovering all the dirt in this year’s cases will prove just as arduous. Perhaps investigators should hire some of Blue Bottle’s nosy techies to help them.