Shadow Trading, Corporate Investments, and Macroeconomic Risk


Yoon-Ho Alex Lee
Professor of Law at the Northwestern University School of Law
Lawrence Liu
Department of Physics and Astronomy, University of Southern California
Alessandro Romano
Assistant Professor of Law at Bocconi University

Corporate insiders engage in ‘shadow trading’ when they use private information pertaining to their own firm to trade in the shares of economically connected companies. While the profitability of shadow trading has long been recognized, SEC v. Panuwata case in which a business development head of a pharmaceutical company traded in the stocks of a competitor—has reinvigorated the debate on the consequences of shadow trading and the extent to which it ought to be regulated.  We investigate these issues in a pair of forthcoming papers. In the first paper, we study the consequences of shadow trading on corporate investment choices. In the second paper, we focus on the macroeconomic consequences of shadow trading.

Our first paper develops a formal model to analyze the incentives created by shadow trading—specifically, how shadow trading might affect corporate investment choices. To begin with, we show that shadow trading can allow a firm to externalize part of the cost of its insiders’ compensation packages. Because insiders have opportunities to profit from trading in the shares of connected companies, in a competitive labor market, they will be willing to accept lower salaries or performance-based pays. In addition, the possibility of engaging in shadow trading can increase managers’ risk appetite. By engaging in risky investment strategies, insiders can amplify fluctuations in the stock price of connected companies, which offer profitable trading opportunities as long as the insiders can learn about the outcomes of such risky projects before the market at large. In itself, this is not necessarily undesirable from the shareholders’ perspective. Indeed, one argument advanced in favor of permitting (classical) insider trades is that managers’ private risk aversion might pull them toward a more conservative investment policy than shareholders would prefer.

However, as we discuss in our second paper, combining the model’s result with the findings from the macroeconomic literature leads to the worrisome conclusion that shadow trading can increase the level of macroeconomic risk to which the economy is exposed. On the one hand, the macroeconomic literature has uncovered that a specific subset of ‘central’ firms can impose large economic externalities and trigger aggregate fluctuations. On the other hand, because shocks at these firms also tend to have a larger impact on connected companies’ stock prices, insiders of central firms can reap larger profits (than those at other firms) by creating risk and engaging in shadow trading. Put differently, the possibility to engage in shadow trading gives greater incentives to pursue risky investment projects to the insiders of those firms who have a disproportionate impact on the economy.

Another important insight of our model is that in some cases shadow trading can lead both insiders and shareholders to prefer negative-expected-value projects over positive-expected-value ones.  This contrasts with a standard finding relating to classical insider trading: even when a manager’s compensation includes profits from insider trading, such an arrangement would not lead shareholders to prefer inefficient or negative-expected-value projects. Ultimately, the reason why shareholders may prefer negative-expected-value projects is that they can profit from their corporation’s own trades or otherwise save on the manager’s compensation. This alignment of incentives can further increase the spillover risks on connected companies.

Our model also considers the case in which shareholders do not anticipate that the manager may engage in shadow trading. In this scenario, the manager can strategically thwart the expectation of the shareholders—in terms of her project choice—to create another opportunity for profitable shadow trades. The manager’s seemingly irrational choice of project can then become a surprise event, which in turn results in a further change in the firm’s value. In these instances, shadow trading can increase market volatility, a finding which confirms that allowing shadow trading can result in negative externalities. Finally, in an extension, we also consider a Perfect Bayesian equilibrium under which the manager employs a mixed strategy in choosing between the two projects and the shareholders form a consistent belief regarding the manager’s project choice.

What are some policy implications of our findings? Our model provides one justification as to why shadow trading ought to be illegal when the firm has an explicit prohibition against it. As noted above, by allowing its insiders to engage in shadow trading, a firm can benefit from externalizing part of the compensation package of its insiders on connected companies. However, allowing shadow trading can also affect the insiders’ risk propensity and the corporation’s investment strategies. Thus, a firm’s deliberate choice to ban shadow trading can be read as a reasoned decision that it prefers to forego the savings associated with the compensation package, presumably because it considers the incentives given by shadow trades costly on net. Meanwhile, the results of our model do not compel us to a specific conclusion regarding how shadow trading ought to be regulated in cases where firms do not themselves ban shadow trades. The picture changes drastically, however, when one also considers the macroeconomic consequences of shadow trading, which we discuss in our second paper. If shadow trading can create macroeconomic externalities, the decision as to whether to regulate shadow trading should not depend only on the impact that shadow trading can have on the firm. Indeed, if shadow trading at some firms can have negative macroeconomic consequences, the case for regulating shadow trading (at least within such firms) appears much more compelling. At a minimum, we believe there should be greater transparency regarding firms’ shadow trading policies for their employees as well as their policies for corporate purchases and sales of stocks in other companies.

Yoon-Ho Alex Lee is Professor of Law at the Northwestern University School of Law.

Lawrence Liu is with the Department of Physics and Astronomy, University of Southern California.

Alessandro Romano is Assistant Professor of Law at the Bocconi Law School.


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