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Government insider trading – is the cynicism justified?

Officials at the US Federal Reserve have come under recent scrutiny following allegations of trading of non-public information. The Fed chair, Jerome Powell, swiftly took action to reassure onlookers and prevent any further perceived conflicts of interest, but the wider issue of government officials trading on insider knowledge remains a problem. The US congress is particularly vulnerable to this, as it seems a $200 fine for such acts has not acted as a deterrent. We have frequently seen repeated breaches of Congress trading and disclosure laws with little consequences for the rule-breakers as they are in such a position of power. The resulting lack of faith in the government poses a serious problem.

Insider Trading

First of all, it is important to understand what insider trading is and why regulators are so keen to tackle it. Essentially, insider trading can be seen as the trading of a public company’s stock (or other asset class) based upon non-public information. Though an argument can be made in favour of this based on an extreme interpretation of the efficient market hypothesis, whereby such market moves increase efficiency, the overwhelming consensus is this has a negative impact on the markets as a whole. Retail traders are likely to be put off by the presence of such information asymmetries, as beating the market becomes significantly harder. This has the knock on effect of making it more difficult for companies to raise capital as some investors become sceptical. There are additional problems for Over the Counter trades (tailor-made instruments including various forms of derivatives), as underwriters would become less willing to issue these instruments at all if insider trading was taking place on a large scale. Despite these consequences, insider trading is extremely difficult to prosecute due to the ambiguity of motive for placing a trade and reasoning behind price movements, as reflected by the fact that the FCA have had only 12 successful convictions in the past five years.

The Fed

On the 18th of October, American Prospect, an American political magazine, reported on Jerome Powell’s liquidation worth between $1-5m that took place in October 2020, arguing that he might have exploited his position as federal reserve chair for a quick profit. To provide some context, Powell built up his wealth working at various private equity firms and is now worth somewhere between roughly $20m and $55m. Upon closer examination, the evidence does not seem compelling. During this time period, he had already expressed his potentially market-moving views at the important Jackson Hole speech, and had actually missed out on a potential 35% gain that he would have made if he kept holding, which suggests that the explanation that he was removing the funds for family use is plausible. The additional fact that these trades covered the whole market and a variety of asset classes further supports him, as insider trading is particularly prevalent when confined to specific stocks.

Nonetheless, Powell has recognised the potential implications of being accused of insider trading for the federal reserve. From now on, the Fed has banned policy makers from trading individual stocks or bonds, requiring any transactions to be approved by an ethics officer. It will also implement a trading blackout during times of high financial volatility, where markets may be more vulnerable to corrections based on non-public knowledge. Other members of the Fed have drawn their own scrutiny in a similar manner to Powell, but these measures are likely to be enough to keep doubts away. This is all the more important with Biden’s decision concerning Powell’s reappointment as Fed chair approaching in February next year, though that is a debate in itself. The old paradigm of allowing Fed officials to actively manage portfolios in compensation for the relatively ‘low’ salary is coming to an end as we demand and expect true commitment to roles of decision making and significant influence.

Congress and politicians

Congress/politics, on the other hand, tells a different story when it comes to tackling insider trading, especially with public trust in politicians at near all-time lows. The key piece of legislation against insider trading is the suitably named STOCK act of 2012, standing for Stop Trading on Congressional Knowledge. This prohibits the use of non-public information for private profit, as well as requiring all trades to be disclosed within 45 days of execution. Various academic studies have come to multiple conclusions about the ability of Congress officials to choose individual stocks and other instruments, but when looking at individual cases we see a compelling argument that officials are trading on Congressional knowledge with few consequences.

Nancy Pelosi, Speaker of the House, has gained a particular reputation for insider trading on social media outlets such as Tik Tok. Users are speculating that she has been using her position of power in law-making to seek above-market returns, such as when her husband invested in NVDA before it was announced they had won a contract with the US government relating to supercomputers, sending the stock high. From Pelosi’s disclosed positions, we can see that her husband and her are up 20-30% since their initial investment . With repeated, well-timed moves, it’s no surprise to see the circulation of statements such as ‘I’ve come to the conclusion that Nancy Pelosi is a psychic.”

Though we may be left speculating in prominent cases like this, there are many others where Congressional officials have been found guilty of insider trading. A recent example of this came in February 2020, when the Senate Intelligence Committee Chairman, Richard Burr, privately warned a group of senators about COVID and its likely impact on the US economy. Many of the senators present then sold personal stocks worth millions over the coming days in anticipation of a market correction. Burr himself sold between $628,000 and $1.7m just a week after reassuring the public that the US had adequate virus measures in place. When asked in March after the crash, his representative simply responded with ‘lol’ before later clarifying that Burr was concerned with the impact on the economy. Another example came in April 2020, when the wife of Mike Kelly, an Ohio senator, purchased a large quantity of stocks in her husband’s district. Shortly after this, her husband announced a recovery package that included the company, which sent the stock price up and brought in a tidy profit. A Congressional ethics watchdog found there to be substantial reason to believe insider trading took place, though the house has not taken any action to punish the individuals, though it is the only agency with the power to do so. Even when there has been clear wrongdoing in acting off non-public information, the fact that it is so difficult to prosecute those in powerful positions has led to a widespread complacency, as Insider found over 42 individuals who had broken the STOCK act and faced little punishment.

Looking ahead

Overall, the difference in responses from the Fed and Congress illustrate the effectiveness of various approaches to deal with insider trading. The Fed took quick action to reassure market participants there was no conflict of interest, whilst Congress, partly due to the complexities of prosecuting insider trading and the large amount of bureaucracy, has done little since 2012 to show offenders that their actions have consequences. With growing scrutiny on various social media platforms about the unfair advantages of politicians, the US government should take action to show that it understands the serious consequences that follow when investors lose faith in politicians, and even more worryingly, when the public loses faith in the fairness of the market.

Sources

https://www.ft.com/content/d358ec51-c47c-469b-8027-00a2332fdcd3

https://www.bloomberg.com/opinion/articles/2021-10-19/jerome-powell-s-stock-dump-doesn-t-look-like-insider-trading

https://www.investopedia.com/tiktokers-track-lawmakers-personal-stock-trades-5206454

https://www.businessinsider.com/congress-stock-act-violations-senate-house-trading-2021-9?r=US&IR=T

https://www.marketwatch.com/story/watchdog-says-substantial-reason-to-believe-that-congressmans-wife-used-insider-info-in-stock-trade-01634934580

https://www.npr.org/2021/09/21/1039313011/tiktokers-are-trading-stocks-by-watching-what-members-of-congress-do?t=1635099084077

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