Insider Trading Case Can Serve as a Model for Market Regulation

In a story that could serve as the plotline for a sequel to Oliver Stone's Wall Street (which is, incidentally forthcoming) a former Ropes & Gray associate became the sixth person to plead guilty in what prosecutors are calling the largest ever hedge fund-related insider trading scheme. With everything from secret code names to computer hacking and cash payoffs, the case is certainly entertaining. However, what of the claim that this is the largest ever insider trading scheme? At an estimated $53 million, the resulting profits are certainly not inconsequential. However, I think it is more likely that this is merely the largest scheme which has been uncovered. Despite this, I believe that it is a great example of how financial industry regulation could ideally work.

I know people who work in money management, and despite the bad press the industry has received recently, not everyone in the business is an unscrupulous real-life Gordon Gekko. However, the hedge fund industry has been estimated to be a trillion dollar business, and recent events highlight what greed can do to previously revered members of the financial community. Hedge funds, with their 2 and 20 compensation schemes and nearly continuous performance assessment, create great pressure on managers to gain an edge. Because of this, it is actually surprising that more insider trading cases do not materialize.

Some say that the solution to this is to regulate compensation schemes, or more broadly, the industry itself. However, the fact that there is a marketplace for the services of hedge fund managers under the current compensation standards indicates that people are willing to pay money for specialized expertise in specialized markets. Addtionally, ex-ante regulation can be tremendously expensive, a fact which can't be ignored during a period of record deficits. That is why big cases like this are so important. More impactful than the punitive effects on the perpetrators of the schemes themselves are the deterrent effects on potential rulebreakers.

The stock market is too often an insider's only club in what should be the most populist of markets. Realistically, cases like this are more than likely just the tip of the iceberg, a fact that prosecutors and regulators should remember before patting themselves too generously on their respective backs. However, it is a start, and could also serve as a model for financial regulation. Instead of putting further systems in place to regulate the financial markets, more cases like this could be just the fix for unfair play, creating a disincentive to cheat, and ultimately an equal playing field for all.