Law & Banking/Finance Web Seminar Series: Alessandro Romano (Yale Law School/Bocconi University)
Title: Insider Trading and Systemic Crises (joint work with Yoon-Ho Alex, Northwestern Pritzker School of Law)
Speaker: Alessandro Romano (Yale Law School)
Abstract: Current insider trading law prohibits, among other things, a company insider from trading in the stocks of her own company based on material non-public information. But the law comes short of prohibiting such an insider from trading in the stocks of connected companies (e.g., suppliers, consumers, and competitors) based on the same information. Such "network trades", however, can generate handsome profits in today’s economy where firms are interconnected and a shock to one company can easily propagate in a predictable manner to the companies with which it is connected. In this Article, we argue that network trades create a moral hazard problem because they allow insiders to profit from risk-creation. Specifically, by investing in a risky project an insider can produce large fluctuations in the stock price of her company and that of the connected firms. She can then use her privileged position to obtain early information on the direction of these fluctuations and profit by engaging in network trades. Most importantly, the insights from network theory reveal that risk creation is more profitable for insiders that operate in industries that have a larger impact on macroeconomic risk. As a result, network trades can play a key role in increasing the overall level of risk to which the economy is exposed and in exacerbating the consequences of crises, such as the one induced by COVID-19. This insight offers a new and powerful rationale for regulating trades made by insiders on material non-public information. We discuss the policy implications of this framework. This framework also has implications for the regulation of trades by insiders on private material information in the shares of their own company.