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Marsden's Electronic Trading Model
To Help Curb Insider Trading
September 20, 1999

As the frenzy for Internet stocks adds fuel to the drive to create new electronic trading networks, a UConn researcher and a colleague have designed a new model for stock markets of the future that could make it much harder to illegally profit from insider trading.

The principle of transparency of information helps makes stock markets competitive markets. The more useful the information and the more freely available, the more competitive the exchanges. Conversely, the less freely information circulates, the easier markets are to rig. Currently, the true open competitiveness of stock markets relies upon the effectiveness of rules against activities such as insider trading.

Advances in computer technology enable electronic trading networks to be structured in ways to neutralize the value of behind-the-scenes information says James Marsden, head of the School of Business Administration's Department of Operations and Information Management, home of the new Treibick Electronic Research Initiative.

"If we can develop an electronic market that allows people to easily track trading activity as it occurs, then we can significantly diminish the benefits of insider trading," he explains. "With the current advances in information technology, I think such a scenario is now or soon will be possible."

To test that idea, Marsden and Y. Alex Tung of the University of Nevada, created an electronic exchange market to conduct experiments designed to level the playing field by rapidly detecting and sharing insider information and imposing electronic penalties on insider traders.

A report on their findings appears in the current issue of Management Science, a leading journal published by the Institute for Operations Research and the Management Sciences. The study was also recently featured as the lead story in the Web edition of Wired News.

For their experiments, Marsden and Tung designed a computerized trading mechanism that allowed them to accurately monitor, track and record the trading behavior and market outcomes of four separate groups of student participants as they traded securities. For the experiments, random student traders were given access to insider information.

In the first set of experiments, the researchers found strong evidence that insiders earn significantly higher financial rewards than the market average. It was possible, however, to eliminate this advantage by use of monetary penalties whenever electronic monitoring found evidence of insider trading.

But it is unlikely this approach could effectively be implemented in large markets. A key stumbling block would remain the ability to identify true insiders, a group that may contain a firm's CEO, an acquaintance of the CEO, or, in one recently reported SEC investigation, the psychiatrist of the wife of the CEO.

To address this problem, Marsden and Tung conducted a second set of experiments where using electronic communication, traders could easily track each other's stock orders. The market featured periodic, rather than continuous, trade completion and market price adjustment.

Thus if one trader had inside information about a company and put in a large purchase order for stock, the computerized system enabled other traders to observe this activity and modify their trading activity accordingly.

The results indicated no significant difference between the performance (portfolio return) of traders with inside information and traders without inside information. So despite the presence of inside information in the market, the playing field was leveled. This result occurred without the use of penalties or regulations.

"What we tried to do was create a system that would put ordinary consumers on an even footing," Marsden explains. "It's a practical solution. If your goal is to get rid of effects of insider trading, one answer is to structure the market differently.

"We have lots and lots of rules about insider trading, but they still have to be enforced," Marsden adds. "Our experimental system had the same effect (as enforcing rules), without significant cost."

While major securities firms in the United States remain key backers of the New York Stock Exchange and Nasdaq, a variety of new electronic trading networks have begun to steal some of the business of matching buy and sell orders for stocks away from these traditional exchanges. Exactly how electronic trading will eventually effect the marketplace is uncertain, but Marsden notes that stock markets are slowly restructuring. Several, for example, have moved to offer after-hours trading, operating under a different set of rules.

Marsden suggests that if exchanges structure different rules and trading environments for after-hour markets and trading, investors will then have distinct choices of markets in which they can participate. This type of competition enables investors to choose or "vote their investment dollars," perhaps adding pressure on exchanges to restructure.

Marsden acknowledges his recent experiments do not directly address large, complex stock exchanges like the New York Stock Exchange. The insurmountable barrier when dealing with major exchanges has been reducing their complexity, he notes. Now, however, high-tech advances can simplify the markets of the future.

"The continuing rapid innovation of information technology makes possible tracking and analysis that are the equivalent of market simplification," he says. "Information technology not only enables the change but will hasten the change, because we can restructure the system to better level the playing field. A few years down the line, we could see significant advances."

David Bauman