Regulating 'Information Leakage'

The authors say the unofficial name for this project has been their "Martha Stewart paper," and they refer to the famous home design and media mogul in their introduction and conclusion. Stewart was convicted in 2004 of making false statements to federal investigators, among other charges.

"The type of information leakage (or piggybacking) present in the Martha Stewart case may actually be more generally present in the brokerage business than that single case may imply," the paper states. "In fact, our results suggest that current regulations, or at least their enforcement, may not fully contemplate this sort of information transfer. In the unsettled debate about whether and how insider trading should be tightly regulated, those who endorse a laissez-faire approach may believe that insider trading improves market efficiency.

"However, the insider information leakage documented in this paper leads to almost no improvement in market efficiency through insider-affiliated market makers, because the public discovers the information about insider trading within a few days."

In reflecting on the other scandals that rocked the markets since the beginning of the period that they studied so closely, from Enron to Bernie Madoff's alleged pyramid scheme, Géczy says his and Yan's findings mean that regulators "need to continue to take a close look at the structures of markets. The conflicts of interest are really very serious and still exist all over the place."

All these things are "part of a cloth that we have woven for ourselves in which regulatory authorities have a very difficult job with heavy resource demands, but one that we rely upon getting done well, efficiently and effectively," Géczy says. The end result here, he adds, "may be that we find ourselves paying more for the regulatory function. The SEC may ultimately claim that it didn't have enough resources to have caught Madoff, that it would have cost too much to guarantee that outcome. Well, as a society, we have to weigh the costs against the benefits of such oversight."