How exchange regulations can mitigate informed trading

On the 17th of June 1995, the London Stock Exchange (‘LSE’) introduced the Alternative Investment Market (‘AIM’) a lightly regulated, secondary market that targets small and high-growth firms. Soon after its creation, the AIM started attracting firms from all over the world and gaining reputation. It is now considered the most popular secondary market in the world, while its success has spawned the establishment of several secondary markets globally that follow similar principles and regulatory features. Some examples include the Euronext Growth Market that operates in Belgium, France, Italy and Portugal, and the Nasdaq's First North that operates in Nordic countries.

Along with the launch of the AIM, the LSE introduced a distinct type of exchange regulation, the Nominated Advisers (Nomads). The Nomads are the key advisors and monitoring mechanism of the AIM. Firms that intend to join the AIM must appoint a Nomad 12 to 24 weeks prior to their admission and retain one during their entire period of listing. Most of the times, the Nomads are investment banks, accountancy, or corporate finance firms.

The Nomads should guide the firms that are interested to join the AIM during the flotation process by overseeing and being actively involved in the preparation of the admission documents. Further to their responsibilities upon admission to the firm, the Nomads must maintain regular contact with, and guide and oversee, the firms during their entire time in the AIM. Importantly, the Nomads must ensure that firms fully understand their obligations under the ‘AIM rules for companies’ and are tasked with monitoring the trading activity in the securities of the firms they supervise, especially when there is unpublished price sensitive information in relation to these companies. This brings into the spotlight the critical role of Nomads in terms of reducing potential price sensitive information leakages in the market.

Finally, the Nomads can also act as brokers in the firm they advise/monitor. In practice the majority of firms hire the same company to act both as Nomad and broker due to potential benefits (eg reduced fees, more specialized/tailored guidance). Having the same company to act in both roles could provide better control over the company but on the other hand it could also lead to conflicts of interest if appropriate safeguards are not in place.

Examination and key findings

In our recent study, we examine the effectiveness of this distinct type of exchange regulation and investigate whether it could act as a tool against market abuse. More specifically, we explore whether highly reputable Nomads (those with the highest market shares in terms of new issues and proceeds) could potentially reduce the level of price sensitive information leakage in the stock market. To do so we examine whether reputable Nomads reduce the patterns of abnormal price activities due to leakages of private information prior to the switches between the AIM and the traditional regulated main market of the UK. These market switches are corporate events that might leave space for investors with inside information to engage in market abusive activities, as we document in our study.

The results show that reputable Nomads significantly mitigate the abnormal pre-announcement price activities prior to market switches, highlighting that exchange regulations can play an effective role in reducing informed trading. However, this type of regulation does not come without limitations. Specifically, the effect of reputable Nomads in reducing informed trading diminishes when Nomads also act as brokers in firms they monitor. This raises concerns as to whether Nomads take the appropriate safeguards to eliminate conflicts of interest that might arise by acting in both roles.

Hence, the LSE needs to reflect on designing appropriate safeguards to mitigate conflicts of interest that may arise when Nomads act in two different roles for the same client/advisee. For example, it could ensure that safeguards such as separating the part of the entity that acts as a monitoring mechanism from the part that acts as a broker (ie Chinese walls) are in place.

Antonios Siganos is Professor of Finance at Edinburgh Napier University.

Angelos Synapis is Assistant Professor of Finance at the Centre for Financial and Corporate Integrity at Coventry University.

Ioannis Tsalavoutas is Professor of Accounting and Finance at the University of Glasgow.

The paper is available here.