Wealth or Stealth? The Camouflage Effect in Insider Trading

TL;DR

This paper models insider trading as a stealthy activity exploiting liquidity to evade detection, analyzing equilibrium behaviors and the impact of legal penalties through theoretical and empirical methods.

Contribution

It introduces a Kyle-type model incorporating legal penalties and a large population, revealing equilibrium existence, convergence properties, and the role of stealth in insider trading.

Findings

Equilibrium exists for various population sizes.

Stealth index $$ determines insider trading scale.

Large populations are crucial for realistic insider trading models.

Abstract

We consider a Kyle-type model where insider trading takes place among a potentially large population of liquidity traders and is subject to legal penalties. Insiders exploit the liquidity provided by the trading masses to "camouflage" their actions and balance expected wealth with the necessary stealth to avoid detection. Under a diverse spectrum of prosecution schemes, we establish the existence of equilibria for arbitrary population sizes and a unique limiting equilibrium. A convergence analysis determines the scale of insider trading by a stealth index $\gamma$, revealing that the equilibrium can be closely approximated by a simple limit due to diminished price informativeness. Empirical aspects are derived from two calibration experiments using non-overlapping data sets spanning from 1980 to 2018, which underline the indispensable role of a large population in insider trading models with legal risk, along with important implications for the incidence of stealth trading and the deterrent effect of legal enforcement.