Summary of: Strategic insider trading and its

consequences for outsiders: Evidence from the

The paper uses historical data to examine the strategic trading behavior of insiders and its impact on
outsiders. It finds that insiders with access to private information can capitalize on their advantage by
hiding their identity and timing their trades, leading to significant post-trade return gaps between
insiders and outsiders. Both experienced and inexperienced outsiders face expected losses due to
this strategic insider trading behavior, which is consistent with theoretical predictions. The study
provides empirical evidence on the consequences of insider trading in a market with no legal
restrictions and non-anonymous trading.

Introduction

Information asymmetry poses a threat to financial market fairness and integrity. This paper examines
insider trading behavior and its impact on outsiders using historical data from early 18th-century
London stock markets. It investigates the value of private information for insiders, their strategic timing
and anonymity in trading, and the financial consequences for outsiders. The findings suggest that
insiders outperform outsiders, especially directors, due to access to valuable private information.
Outsiders suffer expected losses when trading with insiders, particularly informed ones. Experienced
traders avoid trading with directors, indicating the importance of financial knowledge in navigating
insider trading risks.

Historical setting

The early 18th century London stock market experienced a surge of new company offerings in 1720,
leading to a financial bubble known as the South Sea Bubble. While most new initiatives were halted
by the Bubble Act, the Royal Exchange Assurance and London Assurance insurance companies
survived. The Bank of England, East India Company, and Royal African Company were major
players, with the Bank contributing to the bubble by allowing shareholders to borrow against their
shares. The bubble's burst triggered a market-wide price and liquidity crisis, forcing borrowers to sell
shares to repay loans.

Data

The study utilizes data from three main sources: Bank and East India ledger books, Royal African
transfer files, and board meeting minutes. The ledger books provide detailed information on stock
transactions, trader identities, and shareholder characteristics. Board meeting minutes offer insights
into day-to-day business operations and dividend payments. The data set includes 14,200
shareholders, with 119 insiders (directors). Shareholders trade frequently, and insiders tend to hold
larger stock portfolios than outsiders. Descriptive statistics show that insiders outperform outsiders in
trade timing, suggesting directors may have superior information. The study explores different insider
definitions, including expanding the set to include employees, blockholders, politicians, brokers,
nobles, and neighbors of directors, based on potential access to insider information. Insider trading
around dividend announcements is not observed due to the predictability of dividends. Stock price
data and dividend payments are used to compute stock returns, revealing the impact of the South Sea
Bubble in 1720 on share prices.
Results

This section of the research paper examines the impact of private information shared in board
meetings on trading activity and stock returns. The analysis, based on discussions in Bank of England
and East India Company board meetings, reveals that directors trade on material non-public
information obtained in these meetings. Results indicate that directors increase (decrease) holdings in
their company's stock when positive (negative) news is discussed, leading to significant impacts on
trading activity and stock returns. Additionally, the study highlights how insiders strategically hide
trades to capitalize on their information advantage, resulting in higher profitability.

Conclusion

This paper presents empirical findings on insider trading behavior in the early 18th-century London
stock market, utilizing unique data sets. It highlights how directors strategically trade on private
information, showcasing that their post-trade returns outperform other traders significantly. The study
also reveals that directors disguise their informed trades through intermediaries to gain higher returns.
Additionally, it quantifies outsiders' expected losses due to insider trading and demonstrates that more
knowledgeable outsiders are less likely to engage with insiders. Overall, the study emphasizes the
impact of insider trading on outsiders and highlights the importance of trade anonymity in the historical
stock market setting.

Appendix A. South Sea Bubble

The South Sea Company, chartered in 1711, obtained the Asiento in 1713 for slave trade but focused
on sovereign lending. It converted government annuities into tradeable shares, relieving the
government of illiquid debt. The Company's profitability depended on deals with the government and
annuity holders, with share price crucial for converting annuities efficiently. In 1720, multiple share
batches were issued, driving prices up until a financing default led to a crash. The Bank of England
bailed out the South Sea Company due to liquidity issues.

B.1. Bank of England opens margin loan facility

The Bank of England introduced a loan facility allowing shareholders to use their shares as collateral
for cash loans. By providing credit, stock prices surged rapidly due to increased demand and limited
supply. Board minutes from April 1720 suggested offering loans to shareholders against Bank stock.
A public announcement followed, stating that the Bank would lend money to shareholders at 5%
interest for trade, leading to a 4-5% increase in their actions. Both the Bank of England and the South
Sea Company aimed to stimulate trade and benefit the public.

B.2. Loan for government refinancing

The Bank of England provided a loan of £2,500,000 to the British government for refinancing existing
debt, aiming to decrease interest rates on outstanding debt. This financial arrangement not only
ensured a steady income for the Bank but also bolstered its relationship with the government,
potentially benefiting the Bank's stock value. The loan terms specified a 5% interest rate for
redeeming public funds, with flexibility on timings and amounts as deemed necessary until Lady Day
1718. The agreement included utilizing the loan amount to circulate Exchequer Bills at a reduced rate.
B.3. Bank calls collateralized loans to stop bank run

The Bank of England in 1720 faced a bank run prompting them to call 25% of loans backed by stocks.
This move signaled financial distress, likely impacting share prices negatively. The decision was
recorded in the board minutes of 29th September, with loans due by 12th October. Financial strain
was evident in subsequent October notes, mentioning money scarcity and ongoing bank runs.
Attempts to address demands included calling in loans, issuing Bank notes with 5% interest, and
receiving a substantial contribution from the Prince to meet obligations.

B.4. Government redeems annuities held by the Bank

The British government passed a law on February 13, 1724 to repay 5% annuities held by the Bank of
England, reducing the Bank's sovereign debt exposure and providing a capital inflow. This news was
expected to have a positive effect on the Bank's stock prices. The House of Commons passed a
resolution to redeem the £1,775,027 owed to the Bank at the Feast of St. John the Baptist in 1725, in
accordance with the original terms. This action was intended to lessen the public debts and
incumbrances.

B.5. Arrival of three ships with valuable cargoes

The research paper describes the significant arrival of three ships, Marlborough, Rochester, and
Prince Frederick, from the East Indies with valuable cargoes in 1718. These ships brought crucial
news through letters, which was a primary source of information for the East India Company. The
letters included details from the deputy governor and council of fort Marlborough and the chief and
council of Calicut. The total value of the cargoes was £500,000, emphasizing the economic
importance of these shipments. Additionally, the arrival hinted at the potential arrival of five more East
India ships with valuable cargoes shortly.

B.6. Proposal to buy large number of South Sea

In December 1720, the British government urged the East India Company to buy £9,000,000 worth of
South Sea Company stocks to restore public confidence post-bubble burst. The proposal exceeded
East India Company's capital, causing concern and potentially decreasing dividends from 10% to 8%.
The board debated the proposal's implications, ultimately adjourning without a decision due to
objections over dividend reduction. The Caledonian Mercury reported on the general court meeting
where concerns were raised about decreased dividends, leading to an adjournment in hopes of better
terms.

B.7. French buying up large quantities of goods in India

French ships loaded with large sums of money are purchasing significant quantities of goods in India,
causing a shortage and concern for the East India Company. Reports mention 5 French ships with 40
guns each arriving in India from the South Seas to buy goods like pepper, saltpetre, red earth, copper,
tin, coffee, and tea. Their avoidance of prohibited items like silks and calicoes is noted. The French
attempt to acquire two large ships in Batavia but face rejection. Speculations arise about their
destination in Europe, possibly London or Venice, to avoid seizure in France or Spain upon arrival.

B.8. Sinking of ship leads to large losses

The East India Company received a letter informing them about the sinking of the van Sittart merchant
ship near the Isle of May, carrying a significant amount of silver. Shareholders faced substantial
losses due to the shipwreck. The board meeting on June 11, 1719, discussed the letter from Captain
Hyde, detailing the shipwreck on March 2, 1719. Additional reports highlighted the scale of the
disaster, with the Van Cittern, a 550-ton East India Company merchant ship worth £100,000, split on a
rock with valuable silver cargo onboard, resulting in minimal crew casualties.