In this article we argue that the definition of inside information in Article 7.1(a) of the EU Market Abuse Regulation (No. 596/2014)[1] (MAR) [1] is not fit for purpose. From a critical standpoint we argue that given recent technological advances in banking and finance industry, the legal framework is not sufficient to cover full spectrum of digital, human as well as generative AI generated content appearing across global market structures [2]. First, we expand on the overall umbrella definition related to market abuse and relevant issues related to market manipulation. Then, we explore underlying details of the insider trading definition breaking down each component of the Article 7.1(a) of the MAR in part.
Market Abuse and Market Manipulation
Market abuse refers to any activity that distorts the price setting mechanism or the format of prices in a financial market. It refers to actions that are intended to manipulate or deceive market participants in order to gain an unfair advantage. Market abuse can take various forms, such as insider trading, market manipulation, or spreading false information. These activities can have detrimental effects on the integrity and efficiency of financial markets and can undermine investor confidence, basically.
Market manipulation can take various forms, including, pump and dump schemes whereby fraudsters artificially inflate the price of a security by spreading positive or misleading information, encouraging others to buy the stock. Once the price has increased, they sell their holdings, leaving other investors with losses. Another variation is insider trading, focus of our paper. Here, trading based on non-public, material information about a company is illegal. Insiders with access to confidential information may use it to gain an unfair advantage in the market. Yet another example is spoofing and layering. In this case, traders place large orders they have no intention of executing to create an illusion of supply or demand. Once the market reacts, they cancel the orders or execute opposite trades to profit from the resulting price movement [3].
The rationale for market regulation is to ensure fair and transparent markets, protect investors, and maintain the integrity of the financial system. Market abuse poses significant risks to these objectives, as it can undermine market confidence and distort price formation. When market participants engage in abusive practices, it can create an uneven playing field, where some investors have access to privileged information or are able to manipulate prices for their own benefit. This not only harms individual investors who may be deceived or disadvantaged, but also erodes trust in the overall market system.
Regulating market abuse is important for several reasons. Firstly, it helps to maintain fair competition and a level playing field for all market participants. By preventing abusive practices, regulators can ensure that investors are able to make informed decisions based on accurate and reliable information. This promotes market efficiency and prevents distortions in price formation. Secondly, market regulation is necessary to protect the interests of investors. Investors rely on the integrity of financial markets to make investment decisions and allocate their capital. When market abuse occurs, it can lead to significant financial losses for individual investors and undermine confidence in the financial system. By regulating market abuse, regulators can provide a framework that encourages trust and confidence in the markets.
Lastly, market regulation is crucial for maintaining the stability of the financial system. Market abuse can create systemic risks that can spread throughout the financial system and have wider economic consequences. For example, if market manipulation leads to inflated asset prices, it can create a bubble that eventually bursts, causing widespread financial instability[2]. By detecting and preventing market abuse, regulators can help to mitigate these risks and safeguard the stability of the financial system.
As mentioned, market abuse can have various forms, below, we expand on the definition of insider trading as provided in Article 7.1(a) of the MAR.
Definition of Inside Information under point (a) of Article 7(1) of the MAR
Under point (a) of Article 7(1) of the Market Abuse Regulation (MAR), inside information is defined as information that, if it were made public, would be likely to have a significant effect on the prices of financial instruments. This definition focuses on the potential impact of the information on the price setting mechanism of the market. Inside information can distort the price format by providing an unfair advantage to individuals who possess it. As mentioned, the concept of inside information is crucial in maintaining the integrity and fairness of financial markets. It ensures that all investors have access to the same information when making investment decisions, preventing any unfair advantages or distortions in price setting. Inside information can range from financial results, mergers and acquisitions, regulatory developments, or any other information that could significantly impact the prices of financial instruments.
To determine whether information constitutes inside information, several factors need to be considered. Firstly, the information must be precise and specific. It should not be general knowledge or mere rumours that lack substance. Secondly, the information must not be publicly available. If the information has already been disclosed to the public, it cannot be considered inside information. Lastly, the information must be likely to have a significant effect on the prices of financial instruments. This means that it should have the potential to lead to a material change in the price or value of a financial instrument, this could be upwards or downwards direction.
The definition of inside information under point (a) of Article 7(1) of the MAR is aimed at protecting market integrity and ensuring a level playing field for all market participants. By prohibiting the use of inside information for personal gain, it helps to maintain investor confidence and trust in financial markets. It also discourages insider trading, which can distort prices and undermine market efficiency.
However, it is a challenge to prove all the attributes of the above definition in actual court proceedings. Prosecuting insider trading cases under the Market Abuse Regulation (MAR) in the European Union (EU) can present several challenges. Proving insider trading requires collecting substantial evidence, including communications, financial transactions, and patterns of trading. Acquiring such evidence can be complex, especially when it involves cross-border transactions and cooperation between multiple jurisdictions. Coordinating efforts and obtaining evidence from various sources can be time-consuming and challenging. Identifying individuals who have access to inside information and have traded based on that information can be challenging as well. Insider trading can involve complex networks of insiders, such as employees, directors, consultants, or individuals who may have received information indirectly. Identifying the chain of information flow and establishing connections between insiders and their trades can be a demanding task.
Furthermore, Insider trading cases require a high burden of proof, as they involve allegations of illegal conduct with serious consequences for the accused. Prosecutors must demonstrate beyond a reasonable doubt that the accused had access to material non-public information and traded based on that information. Establishing a clear and direct link between the information and the trades can be challenging, especially if the trades were conducted through complex financial structures or intermediaries, as this is usually the case. In addition, insider trading cases may involve complex financial transactions, such as derivatives, options, or structured products or digital assets, such as bitcoin or ether. Understanding and unravelling these transactions to identify instances of insider trading can require specialized knowledge and expertise. Prosecutors and investigators need a deep understanding of financial markets and instruments to effectively analyse and present evidence, and as we argue, the regulators and legislators need to review and potentially enhance current insider trading definition as postulated in Article 7.1(a) of the MAR.
As such, in this context, we expand and build our critical analysis of the Article 7.1(a) of the MAR on the BaFin, Federal Financial Supervisory Authority sequence [4], namely:
Inside information refers to specific details or facts rather than general knowledge or speculation. It includes data or knowledge that, if known by the public, could have an impact on the price of financial instruments.
Inside information has not been disclosed to the public. It is confidential and known only to a limited group of people who are privy to such information.
Inside information can pertain to one or more issuers, which are companies whose securities are listed on a regulated market. It can also relate to one or more financial instruments, such as stocks, bonds, derivatives, or any other investment products or any other form of digital assets [3].
Inside information should be of such a nature that, if it were made public, it would likely have a significant impact on the prices of the financial instruments involved. This means that the information has the potential to influence the decisions of a reasonable investors and affect market prices. It is at this stage that we raise a gap in the definition, as about 70% of total trading volumes of financial securities in developed markets stems from algorithmic trading [5] and it is not a “reasonable investor” who builds these trading algorithms but rather sophisticated market operators or “reasonably advanced investor” with full and detailed “inside” knowledge of the intricacies of current global equity, commodity and capital market structures.
Inside information can also impact the prices of derivative financial instruments that are linked to the underlying financial instruments. Derivative instruments, such as options or futures contracts, derive their value from an underlying asset or security. It is here, we raise a gap in the coverage as this definition tend to miss digital assets as additional potential form of a derivative.
Based on the above point 1) and 2), when information is considered public, it means that it has been made available to a wide audience, including an indefinite number of individuals. The source of the information doesn't matter - it can be disclosed by the issuer themselves or through other means, such as a publicly accessible electronic information system. The key is that the information must be available to the general investing public simultaneously, ensuring equal access for all interested market participants. Even if there is a fee to access the electronic information system, it can still be considered generally accessible. However, sharing inside information in a limited stock market information service or news board that caters to specific groups of people does not meet the requirement of making the information available to a broad investing public. Similarly, information that can only be accessed from the commercial register does not qualify as being made public. It is argued that information provided on social media is not ensuring the rapid information dissemination. From critical perspective, this is a space for enhancement of current definition as we argue that if this information is picked up by national press it is already considered obsolete. In short, we note that current automated algorithmic bots are searching on listening to company releases. As such, any dissemination of information should be categorized as public in nature.
Further elaborating on points 3) and 4) above, information is considered precise if it pertains to existing or potential circumstances or events that have occurred or are likely to occur. It must be specific enough to allow for an assessment of its potential impact on the prices of financial instruments, derivative financial instruments, commodity contracts, or emission allowances.
To determine if future circumstances meet the criteria of being precise, it must be reasonably expected that they will come into existence. BaFin applies a standard of 50% + x (more likely than not) in such cases. This involves considering all available information and circumstances, including past outcomes at the company and any relevant factors specific to the case. For example, one might assess whether the company has historically been successful in completing planned acquisitions and consider any unique characteristics of the current situation.
Vague or general information that does not allow for a conclusion to be drawn regarding its potential impact on the prices of financial instruments is not considered precise. The direction of the potential impact on prices is irrelevant in determining whether information is precise. According to the "Lafonta judgment" by the European Court of Justice, information does not need to provide a sufficient degree of probability about its effect on prices to be considered precise [6].
Lastly, expanding on point 5), the information must pertain to issuers of financial instruments or financial instruments themselves, either directly or indirectly. It is not necessary for the circumstances affecting prices to be related to the issuer's field of activity or the issuer or financial instrument. Indirectly related circumstances can also be considered inside information. This includes market data or information about the general market environment or the markets themselves that can impact issuers or financial instruments. Examples of this include interest rate decisions by central banks, exchange rates, commodity prices, sector-specific statistical data, OTC sales of share packages without a strategic objective by major investors, data and information related to trading in the financial instrument such as order volume, type of order, and the identity of the principal, as well as inclusion or removal from an index, compensation offers/squeeze-outs, natural disasters, legislative initiatives or changes in legislation, and other political decisions. According to Article 17(1) of the MAR, “there is no requirement to disclose information that does not directly concern the issuer, although it does activate the prohibitions of insider dealing and disclosure of inside information.”
Conclusion
The definition of inside information in Article 7.1(a) of the EU Market Abuse Regulation (MAR) is a topic that requires critical examination. In the ever-evolving landscape of the banking and finance industry, recent technological advances have brought about new challenges that the current legal framework fails to adequately address. It is clear that the definition of inside information needs to be revisited in order to encompass the full spectrum of digital, human, and generative AI generated content that is now prevalent across global market structures.
Market abuse is a serious issue that can have far-reaching consequences for investors and the overall integrity of financial markets. The definition of inside information plays a crucial role in identifying and preventing market manipulation. However, the current definition falls short when it comes to capturing the complexities of today's digital age. The traditional notion of insider information being limited to material facts that are not yet publicly available is no longer sufficient.
To protect investors and ensure fair and transparent markets, the definition of inside information needs to consider the expectations of a “reasonably advanced” investor in today's technologically advanced world. With the rise of social media, online forums, and algorithmic trading, information travels at lightning speed, making it difficult for the current legal framework to keep up. The definition should encompass not only information that is explicitly disclosed, but also information that can be inferred or derived from various sources.
Furthermore, the advent of generative AI technology introduces a whole new layer of complexity. AI algorithms can generate content that can influence market behaviour. This content may not be produced by humans, but it can still have a significant impact on market prices and investor decisions. Therefore, the definition of inside information should be broadened to include AI-generated content that has the potential to affect market dynamics.
In conclusion, the current definition of inside information in Article 7.1(a) of MAR is not fit for purpose in today's rapidly evolving financial landscape. The legal framework needs to be updated to encompass the full spectrum of digital, human, and generative AI generated content that now influences global market structures. By considering the expectations of a reasonably advanced investor in this technologically advanced era, we can ensure that market abuse is effectively identified and prevented. It is crucial that regulators and lawmakers take proactive steps to revise the definition of inside information to maintain the integrity of financial markets and protect the interests of investors.
References
[1] Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC Text with EEA relevance EUR-Lex, Retrieved from: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32014R0596
[2] SEC Press Release, SEC Charges Eight Social Media Influencers in $100 Million Stock Manipulation Scheme Promoted on Discord and Twitter, Retrieved from: https://www.sec.gov/news/press-release/2022-221
[3] Swiers T., Office of International Affairs, U.S. Securities and Exchange Commission, Retrieved from: https://www.sec.gov/files/Market%20Manipulations%20and%20Case%20Studies.pdf
[4] BaFin, Federal Financial Supervisory Authority, Article: Inside Information under point (a) ot Article 7.1 of the MAR, Retrieved from: BaFin - Inside information under point (a) of Article 7(1) of the MAR
[5] Drakeford, Ch., (2020), “Market Manipulation: Definitional Approaches”, Harvard Law School, The Case Studies, CSP055, Retrieved from:
[6] ECJ, Judgment of 11 March 2015 – C-628/13, available at https://curia.europa.eu
[1] In July 2016, the Market Abuse Regulation (MAR) and the Directive on Criminal sanctions for insider dealing and market manipulation (CRIM-MAD) that replaced previous Market Abuse Directive 2003/6/EC (MAD 2003). Further amends were proposed under UK legislation: Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC (Text with EEA relevance) (legislation.gov.uk) [2] FTX bankruptcy, “Never in my career have I seen such a complete failure of corporate controls . . .” inclusive of deep market manipulation, insider trader among other alleged misconduct, as depicted in a non-regulated crypto markets, reference: The FTX bankruptcy filing in full (updated) | Financial Times [3]Relevant example related to an alternative market structure, in this context, listing various forms of digital assets is tZero: “Digital securities are conventional securities with a blockchain technology overlay, enhancing the issuer and investor experience through customization and transparency. Tokenized assets transform the capital formation process by automating and reducing the costly compliance requirements through a transparent and immutable ledger.”, reference: tZERO