Insider Trading: Wealth vs. Stealth – City University of Hong Kong

Insider trading has long been a subject of fascination in the financial world, with the Kyle-Back Strategic Insider Trading model standing out as a prominent equilibrium model dealing with asymmetric information in market microstructure theory. Over the past four decades, this model has received extensive attention, leading to the introduction of various mathematical tools to solve the solvability challenges it presents. These tools have ranged from stochastic control and filtering to stochastic analysis and optimal transports.

A common optimal strategy observed in insider trading is the “bridge” nature, wherein insiders trade aggressively before the asymmetric information becomes public knowledge. However, this aggressive trading approach carries the risk of detection by regulators, potentially resulting in severe financial and criminal penalties for the insider. In light of these risks, insiders are increasingly seeking to “camouflage” their actions to strike a balance between maximizing expected wealth and avoiding detection and prosecution.

In a recent discussion on this topic, a Kyle-type model was examined where insiders consider legal consequences and aim to conceal their trades to achieve this delicate balance. The core focus of the study was to establish an equilibrium among insiders of varying population sizes and determine a unique limiting equilibrium under certain conditions. The research involved a thorough convergence analysis, shedding light on the optimal scale of trading based on a “stealth index” considered by the insider in relation to the liquidity trader population.

The study revealed that the equilibrium could be closely approximated by a simple limit with minimal price impact. Furthermore, the model was calibrated using two distinct data sets spanning nearly four decades, from 1980 to 2018. This calibration emphasized the significance of stealth trading in the financial landscape and highlighted the deterrent effect of civil and criminal penalties associated with non-compliant behavior.

Through this research, insights were gained into the delicate balance insiders must strike between maximizing wealth through strategic trading and minimizing the risks of detection and punishment. The study showcased the importance of evolving strategies in response to regulatory environments and highlighted the critical role of maintaining a low profile in trading activities to navigate the complex landscape of insider trading.

Overall, the research into the camouflage effect in insider trading underscores the intricate dynamics at play in financial markets and emphasizes the need for insiders to carefully consider the trade-offs between expected wealth accumulation and the imperative need for stealth to avoid legal repercussions.