Commentary & Analysis
In this month’s deep dive, we’ll look at an interesting case working through the United States courts, an example of what has become known as “shadow trading.” This mysteriously named behavior has significant potential to expand how insider trading is defined and create new challenges for compliance teams. It’s doubly interesting as it intersects two long-term trends within the industry: a growing focus on financial crime through related instruments and the increasing prominence of insider trading as a financial crime. As an example of this trend, Ireland had its first insider trading conviction in December 2023. The Commodity and Futures Trading Commission (CFTC) and the U.S. Department of Justice (DOJ) also recently publicized a high-profile case involving traders paying bribes to employees of a South American State-Owned Enterprise who learned material non-public information in physical oil trading, which afterward they profited from by trading in related futures and other derivatives.
A Hypothetical Scenario
In a 2020 research paper, Mihir N. Mehta, David M. Reeb, and Wanli Zhao posed a hypothetical scenario where private information held by an insider can also be relevant to “economically-linked” firms and then exploited for profitable trading in the linked firm. For example, an accountant may learn that his employer plans to purchase a chipmaker. In the traditional insider trading scenario, he would buy shares in the acquisition target and likely be caught by existing controls. In the shadow trading scenario, he is aware that the acquisition would also impact other chipmakers not directly related to the acquisition. For example, the acquisition may make all other smaller chipmakers acquisition targets, and they would then trade those companies. The researchers found prosecutions in the U.S. for shadow trading style activity “virtually non-existent” and gave empirical evidence that it may be happening quite a bit by looking at trading activity in “economically-linked” firms prior to price moving announcements in the source firm.
Into the Real World
In 2021, the scenario moved out of the academic world following a case brought by the U.S. Securities and Exchange Commission (SEC) (SEC v Panuwat). In this case, a (now former) business development executive at Medivation Inc (“Medivation”) learned through a confidential, non-public email from the CEO that his firm was going to be acquired by Pfizer - at a significant premium. Within minutes of learning the news, the executive purchased, using his work computer, out-of-the-money, short-term stock options in a similar and competitor pharmaceutical company to his own (“Incyte”). The SEC argues that the executive was aware that there were multiple bidders for the firm, that there were few firms of that type left to acquire, and that previous announcements of acquisitions of firms of that type had resulted in the stock prices of Medivation and Incyte to go up. On the day of the public announcement of the acquisition, Medivation’s stock price went up 20%. That same day, the stock price of Incyte went up 8%, which was material for that stock. The stock options doubled in price for a profit of $107,066.
Attempts for Summary Judgment
The case continues, surviving a move for a summary judgment in November 2023 and an earlier motion to dismiss. In the earlier motion to dismiss, the Judge ruled that “information may be material to more than one company and that information does not need to come from the issuer of the security to be material.” The case is ongoing; however, the SEC’s position within it represents a significant expansion of the potential scope of insider trading enforcement. This could impact companies’ internal trading policies and, more generally, traders who have access to material non-public information (MNPI). For compliance and surveillance teams, this represents an additional dimension of data that would increase the complexity of detection.
Though this case is U.S.-centric and there are fundamental differences between insider trading rules in the U.S. and Europe, Poelzig and Dittrich at the University of Hamburg propose arguments that shadow trading would be covered under Article 14 of the Market Abuse Regulations, and this would likely be the case for other countries that follow a similar approach.
Irrespective of where you may be located geographically, the current shadow trading discussion is relevant to how we think about insider trading. This is particularly important as we see decreased tolerance and increasingly negative public perception around inside trading, particularly from those in positions of authority. Combating insider trading is essential to ensuring we have a trusted functional market.
Regulatory Updates
20 December: The Swiss Financial Market Supervisory Authority (FINMA) released guidance on staking services, focusing on protecting customers from the risk of staking service providers going bankrupt. The guidance clarifies the legal uncertainties surrounding the custody of staked crypto-assets and emphasizes the need for risk-mitigating measures and transparency in informing customers about the associated risks. Until further clarification is provided, staked crypto-assets will be segregated from bankrupt estates and returned to custody account customers according to FINMA’s assessment.
19 December: The International Organization of Securities Commissions (IOSCO) published its policy recommendations for decentralized finance. The nine Policy Recommendations aim to address market integrity and investor protection concerns arising from DeFi by supporting greater consistency of regulatory frameworks and oversight in member jurisdictions. The Recommendations cover six key areas:
- Understanding DeFi Arrangements and Structures,
- Achieving Common Standards of Regulatory Outcomes
- Identification and Management of Key Risks
- Clear, Accurate and Comprehensive Disclosures
- Enforcement of Applicable Laws
- Cross-Border Cooperation
14 December: The Basel Committee on Banking Supervision published a consultation on targeted adjustments to tighten its standard on banks’ exposures to crypto-assets. The requirements determine whether the stablecoins to which banks may be exposed will be eligible for inclusion in the Group 1b category of crypto-assets and thus benefit from preferential regulatory treatment.
14 December: Italy’s Commissione Nazionale Per Le Societa’ E La Borsa (CONSOB) updated its 2022-2024 Strategic Plan, which highlights two new strategic directions unfolding along two main axes. Two directors will be named, one to oversee “Consob Reform: Technology and Organization” and another for “Competitiveness of the Capital Market: Innovation, Sustainability, and Investor Protection,” each with its own strategic objectives.
13 December: The Australian Transaction Reports and Analysis Centre (AUSTRAC) announced its regulatory priorities for the year ahead, focusing on enhancing understanding and management of money laundering and terrorism financing risks, particularly in the banking, gambling, and remittance sectors. AUSTRAC will also target additional sectors such as digital currency exchanges, payment platforms, bullion, and non-bank lenders to ensure compliance with Anti-Money Laundering and Counter-Terrorism Financing (AML/CTF) requirements.
12 December: The European Securities and Markets Authority (ESMA) published its annual peer review report on the supervision of EU Central Counterparties (CCPs) by National Competent Authorities (NCAs). The Peer Review measured the effectiveness of NCA supervisory practices in assessing CCP compliance with EMIR requirements on the due diligence of clearing members.
8 December: The Bank of England, Prudential Regulation Authority (PRA), and Financial Conduct Authority (FCA) consulted on proposals to strengthen the resilience of services provided by critical third parties (CTPs) to UK-regulated financial services firms and financial market infrastructure entities.
1 December: The Reserve Bank of India (RBI) and the Bank of England (BoE) signed a Memorandum of Understanding (MoU) to enhance cooperation and exchange of information regarding the Clearing Corporation of India Limited (CCIL). This MoU allows the BoE to rely on RBI’s regulatory activities while promoting international clearing activities and facilitating UK banks’ transactions through CCIL. The MoU also emphasizes cross-border collaboration in international clearing activities and the BoE’s commitment to deference to other regulatory regimes.
27 November: The SEC adopted Securities Act Rule 192 to prevent the sale of asset-backed securities tainted by material conflicts of interest. The rule prohibits securitization participants from engaging in conflicted transactions while providing exceptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making activities.
Enforcement Actions & Fines
The Central Bank of Ireland (the Central Bank) reprimanded and fined the investment fund, GlobalReach Multi-Strategy ICAV (the ICAV), €192,500 for breach of its reporting obligation under Article 9(1) of the European Markets Infrastructure Regulation (EMIR), which requires details of any derivative contracts to be reported to a registered trade repository no later than the working day following the conclusion of the contract.
The French Autorite des marchés Financiers (AMF) fined Visiomed €200,000 for disseminating false or misleading information that could have set the price of Visiomed’s shares at an abnormal or artificial level. It also imposed a fine of €100,000 on Negma Group Ltd for breach of its reporting obligations.
The SEC took legal action to halt a $191 million cattle Ponzi scheme conducted by Agridime LLC, which claims to specialize in meat sales, distribution, and animal supply chain management. The case has received considerable media attention in the U.S.
The Australian Securities and Investments Commission (ASIC) fined Instinet Australia Pty Ltd a penalty of $670,500 for violations of market integrity rules. The penalty was in compliance with an infringement notice issued by the Markets Disciplinary Panel (MDP) and related to Instinet’s operation of a crossing system called BLX Australia. The MDP deemed Instinet negligent for lacking procedures to prevent or detect non-compliance with crossing system rules. The MDP also considered that Instinet failed to update its systems in line with market changes and, in doing so, failed to act in its clients’ interests. The MDP said that Instinet’s failure to update its system in response to market changes indicated ‘poor market awareness and a ‘set and forget’ approach’ to compliance.
The U.S. Financial Industry Regulatory Authority (FINRA) fined Bank of America (BofA) Securities, Inc. $24 million for engaging in over 700 instances of spoofing in U.S. Treasury secondary markets. The fraudulent trading involved spoofing in a U.S. Treasury security to induce opposite-side executions in the same Treasury security or a correlated Treasury futures contract.
The SEC charged ArciTerra Companies LLC and its CEO with fraud for misappropriating millions of dollars from investor funds for personal expenses and a lavish lifestyle. The SEC also alleges that the CEO manipulated stock prices through false press releases.
The U.K. Financial Conduct Authority (FCA) fined Dollar East (International Travel & Money Transfer) Ltd, Hafiz Bros Travel & Money Transfer Limited, and LCC Trans-Sending Limited over £150,000 for breaching competition law. The firms coordinated exchange rates and fixed transaction fees, affecting transfers made by customers in Glasgow.
The Commodity Futures Trading Commission (CFTC) filed and settled fraud charges against Freepoint Commodities LLC, a commodities merchant in Connecticut. The company engaged in fraudulent conduct by obtaining and trading on material non-public information from a South American state-owned enterprise (SOE), resulting in a penalty of over $91 million in civil monetary penalties and disgorgement. The information was obtained through bribes from employees at the SOE, and profits were made by trading oil derivatives and related products. This misconduct undermined the integrity of oil markets and violated the Commodity Exchange Act (CEA).
The Dublin Circuit Criminal Court fined the first person convicted of insider trading in the Republic of Ireland. Following an insider briefing, a healthcare worker from Country Antrim made more than £11,000 by “dumping” his holdings in a company days before buying shares at a reduced price.
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