Stephen L. Lenkey
Advance Disclosure of Insider Trading
Review of Financial Studies | Volume 27, Issue 8 (Dec 2015), 2504–2537

Current law requires certain corporate insiders (officers, directors, and large beneficial owners) to publicly disclose their trades within two business days after the trades are made. This mandate facilitates the flow of information to the rest of the market by creating an opportunity for ordinary investors to glean information from insiders' trades. However, the law appears to fall short in preventing insiders from earning insider-trading profits because the trades are revealed only after insiders have had an opportunity to capitalize on their information advantages. Might it not be better, then, to require insiders to disclose their trades before they occur? I show that welfare increases for both insiders and ordinary investors when insiders are required to disclose their trades in advance.

Theoretical framework

I evaluate the desirability of potential regulations that would require insiders to disclose their trades in advance using a strategic rational expectations equilibrium framework. In the model, there is a lone insider who possesses an information advantage over a continuum of less-informed investors. The insider can trade on the basis of her private information to earn insider-trading profits. Before she trades, however, the insider must publicly disclose her trade. This disclosure provides a noisy signal of the insider's private information from which ordinary investors can learn about the insider's information. A nontradeable random endowment received by the insider but unobservable to investors prevents the insider's private information from being fully revealed in equilibrium. As a benchmark against which to evaluate the impact of advance disclosure, I consider an alternative setting in which the insider is free to trade without providing a pretrade disclosure. In the benchmark setting, the stock price acts as a noisy signal of the insider's private information.

Advance disclosure improves risk sharing

Under an advance disclosure requirement, the insider must commit to a trade (and disclose it) without knowing the exact price at which the transaction will occur. This creates greater uncertainty for the insider in the form of price risk. To mitigate this risk, the insider trades less aggressively on her private information, which reduces adverse selection costs incurred by ordinary investors that arise from trading with a better-informed counterparty. Consequently, ordinary investors are more willing to trade when the insider prediscloses. Not only does this enhance the insider's ability to hedge her nontradeable endowment, but it also allows the risk in the economy to be shared more efficiently.

1: Risk Sharing
lenkey-1
Changes in trading aggressiveness (black), hedging ability (red), and the price responsiveness to the insider's information (green) and nontradeable endowment (blue) caused by advance disclosure. We interpret this to mean that investors face lower adverse selection costs and risk sharing improves with advance disclosure.

Figure 1 decomposes the impact of advance disclosure on the price and allocations into informational and risk-sharing effects. The figure shows that the insider trades less aggressively on her private information but more aggressively hedges her nontradable endowment when she prediscloses her trade. Additionally, the price is less sensitive to both the insider's private information and her nontradeable endowment. This stems from the fact that the insider's hedging motive is stronger, whereas her information-based motive for trading is weaker with advance disclosure. The improvement in risk sharing is ultimately manifested in the equilibrium price and allocations. When the insider prediscloses her trade, the price and allocations more accurately reflect the optimal level of risk sharing that would be achieved under a symmetric-information equilibrium.

Advance disclosure also results in a less-efficient market. Even though investors have knowledge of the insider's trade before it occurs, the market is less efficient because less of the insider's information is revealed through her trade when she prediscloses. The insider's trade does not convey as much information because she trades less aggressively on her private information.

Better risk sharing enhances welfare

Advance disclosure tends to increase welfare for the insider, as shown in Figure 2. Despite the fact that making a pretrade disclosure reduces the insider's ability to capitalize on her information advantage, the insider's welfare rises because the improvement in risk sharing enables the insider to better hedge her nontradeable endowment and hold a portfolio that is better aligned with her risk preferences. The insider's welfare increases because the benefits of improved risk sharing outweigh the costs associated with her diminished ability to earn insider-trading profits.

2: Welfare
lenkey-2
This shows certainty equivalents of advance disclosure for the insider in black and for ordinary investors in red. Advance disclosure increases welfare.

Ordinary investors also experience a rise in welfare when the insider prediscloses her trade, as indicated by Figure 2. This occurs because the improvement in risk sharing enables investors to hold portfolios that are better aligned with their risk preferences, even though the market is less efficient with advance disclosure. Investors' welfare increases because the benefits of improved risk sharing offset the greater uncertainty faced by investors.

Advance disclosure alters managerial incentives

Because advance disclosure alters both the information environment and the equilibrium allocations, requiring insiders to disclose their trades in advance affects managerial incentives in at least two ways. First, pretrade disclosure encourages risk taking. Advance disclosure strengthens the incentive for a manager to undertake risky projects because the market is less efficient and, therefore, private information is more valuable when insiders disclose their trades in advance. Second, pretrade disclosure may either encourage or discourage managerial effort. Advance disclosure either strengthens or weakens the incentive for a manager to exert costly effort because the personal benefits from exerting effort depend on an insider's stake in the equity of the firm, and an insider's equilibrium allocation may either rise or fall under advance disclosure.