Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Tue, 21 Mar 2006

Informed trading or insider trading

Regulators seem to have great difficulty in distinguishing between informed trading and insider trading.

A study published in the Occasional Paper Series of the Financial Services Authority of the UK demonstrates that there are large (and statistically significant) abnormal stock returns ahead of takeover announcements. This is clearly evidence of informed trading but not necessarily of insider trading. After all, there is a lot of informed speculation ahead of any bid. The authors try to finesse the problem with an inappropriate definition of insider trading:

Throughout this paper the term “insider trading” is used to mean acting or causing others to act on material non-public information which could affect the value of an investment. This term is not a legal one but is intended to include the UK legal offences of insider dealing and misuse of information.

The financial press has been quoting the study extensively as evidence of insider trading. John Gapper writes in the Financial Times “Last week, [the FSA] said there were signs of insider trading before 29 per cent of UK mergers and acquisitions announcements.” Steve Goldstein wrote an article in headlined “Insider trading rife in U.K. M&A: study ”. The opening sentence of the article uses the phrase “insider trading” while the second paragraph uses the phrase “informed trading”.

This confusion is unfortunate. Informed trading is the life blood of financial markets and if the only way to stop insider trading is to shut down informed trading, then it is far better to live with insider trading.

Posted at 13:37 on Tue, 21 Mar 2006     View/Post Comments (0)     permanent link

Mon, 20 Mar 2006

Advantages of Single Regulator

An interesting IMF Working Paper by Martin Cihak and Richard Podpiera present evidence that single regulators (covering banking, securities and insurance) are associated with higher quality of supervision and with higher consistency of regulation across the three sectors. One of the problems that they face is that integrated regulators are typically found in more developed countries with more mature regulatory environments. They control for both of these in their study. Controlling for income reduces the effect a great deal but it remains positive and in many cases, it also remains statistically significant.

The authors measure quality of regulation by conformance to various international standards on core principles of regulation.

Posted at 18:36 on Mon, 20 Mar 2006     View/Post Comments (2)     permanent link

Tue, 07 Mar 2006

Tobin Tax and Capital Gains

In response to my comments on the Indian budget, Prof. Ramesh Gupta states that the securities transaction tax can be justified as a kind of Tobin tax to discourage speculative transactions. I disagree on two counts. Frist, I do not like the Tobin tax, but I will not get into this in detail because there is a huge literature on the Tobin tax and I do not think I have anything original to say on this subject. My second point of disagreement is more subtle. A Tobin tax and a revenue maximizing transaction tax are very different in terms of the tax rate. As Tobin himself emphasized, the rate of the Tobin tax should be exceedingly small so as not to affect true price discovery. A revenue maximizing transaction tax on the other hand would be much higher.

In India, the transaction tax was introduced as a substitute for the capital gains tax. This I think is a mistake. It forces the government to progressively move the rate towards a revenue maximizing rate and thereby endanger price discovery in the market. I believe that the current rate of the transaction tax is much higher than what a Tobin tax would be. More important is the question of fairness. Ideally, the real returns on all investments should be taxed at the same rate. Today, the return earned on equities is taxed at a negligible rate. Return earned on bonds is taxed at much higher rates as is salary income (which is return earned on investment in human capital). This is unacceptable from a fairness point of view. From a merit point of view also, it is difficult to make out any case for preferring investment in equities to investment in human capital.

Posted at 17:30 on Tue, 07 Mar 2006     View/Post Comments (1)     permanent link

Thu, 02 Mar 2006

Capital gains tax

I wrote a piece in yesterday’s Financial Express about the budget proposal related to capital gains taxation and securities transaction tax. I wrote that the government seems to have realized that its decision two years ago to replace the capital gains tax on securities with a tax on securities transactions was a mistake. My article makes the following points:

Posted at 14:19 on Thu, 02 Mar 2006     View/Post Comments (2)     permanent link