January 29, 2013

Insider trading was once again center stage in 2012 with the by now usual raft of arrests, guilty pleas and high profile trials. The trend has only continued in 2013 with the charging of Matthew Martoma, a former SAC portfolio manager and the continuing swirl of speculation and rumor surrounding SAC itself. The aggressive prosecution of the crime, however, seems insufficient, leading to suggestions that more could be done by the industry to manage the issue. But what? To paraphrase Freud, understanding the problem, will go a long way towards solving it.

The infrastructure of insider trading industry is of course, by design, opaque, since it deals in an illegal substance called inside information. One can't be overly simplistic about this. Unlike drugs, for example, there is some level of ambiguity that makes going after its traffickers somewhat tricky: first, what exactly constitutes "material non-public information" (mnpi); second, how to determine who is in possession of such information and, third;how to identify those who are trading on it with the requisite intent to do so. However, prosecutors have had considerable success in overcoming these obstacles in recent years as they have adopted more aggressive methods. Much of this success has been focused on two types of financial service firms: expert networks, firms who provide consulting advice to trading firms, and hedge funds.

The middlemen in the insider trading industry are the expert networks who can (sometimes unknowingly) link the users (traders) to the suppliers (industry executives, researchers - people with access to inside information). The operation is financed by the users who are willing to pay good rates for the information. The industry is global in its scope. Many of the cases that have been brought have turned on evidence that expert networks provided mnpi to their clients.

Second, as with the drug industry, the inside information industry would not exist without the demand of the users. So who are these users? It would appear, given the number of hedge fund managers charged in recent years, that some hedge fund managers are very significant dealers and users of inside information. Cases in the last three or so years have brought down several major and well-established multi-billion dollar funds, including: Front Point Partners, Galleon Group, Diamondback Capital Management, and New Castle Funds. So what is it about hedge funds that have given rise to this trend?

Hedge funds have grown ever more ubiquitous as more and more traders from large banks, frustrated with red tape and declining pay have left to set up their own shops. These are typically aggressive types, quite different from the portfolio managers of the more traditional and conservative asset management industry. They tend to build very sleek and streamlined organizations with very little infrastructure. It is not so unusual for a young fund to have a billion dollars or more under management with relatively few staff members in operations and a fairly junior "chief financial officer" (cfo) or controller. In some cases hedge funds may take on an experienced CFO to help set up the infrastructure and systems, only to replace him or her with a more junior, and lower paid person once that goal has been achieved. In addition, compliance may be outsourced and there is likely no independent risk management function or investment committee to speak of.