Stock Market Efficiency, Insider Dealing and Market Abuse

A study of regulation finds that it mostly works, but the debate has moved on, says Ranald Michie

June 18, 2009

Casino capitalism or efficient markets? These two phrases capture the extremes of the spectrum through which the stock market is viewed.

For many, what takes place in the stock exchange is no better than gambling on the random fluctuation of prices. It is a place where companies are bought and sold without regard for the consequences. The only ones to profit are those with the power to manipulate prices or possessing insider information.

For other observers, it is central to the efficient operation of the capitalist economy. Changing prices reflect the constant interaction of supply and demand, and provide vital signals to companies and investors. The takeover bid is the means by which poorly performing management teams are replaced.

Paul Barnes takes it as given that a modern economy requires the stock market, and proceeds to discuss whether it operates efficiently, what abuses exist, how significant they are and the measures taken to combat them. This is done through a mix of economics, mathematics and law.

Thus, the book is aimed at those who already have a basic knowledge of stock markets, such as accountants, lawyers and financial-sector staff, and it seeks to question many of the assumptions by which they operate. Given the current economic turmoil, such questioning is vitally important when undertaken from an informed position.

At the core of the book is a discussion of the efficient capital markets hypothesis, which asserts that the current price of securities fully reflects all the available information at each and every moment.

This thesis is carefully explained and forms the basis for understanding the normal working of the stock market. However, it can be shown that important exceptions exist, such as during speculative bubbles, while the information provided in company accounts is as much a matter of judgment as fact.

During a boom and subsequent crash, the stock market can behave irrationally as investors become either overly optimistic or too pessimistic. At certain points, such as prior to a takeover bid, individual investors may be in a position to gain financially from privileged information or to manipulate prices for their own ends.

However, the stock market is not a jungle where buyers and sellers are left to fend for themselves, but rather an arena where conduct is monitored and strictly controlled by rules, guidelines and recommendations.

By taking into account the London Stock Exchange and the Financial Services and Markets Act 2000, Barnes shows that for the market to operate efficiently it must be regulated, and that this is done relatively successfully. Examples of fraud, insider trading and other forms of abuse exist, but appear to be relatively minor, with little effect on the market's efficient operation. Of greater concern is the close relationship that can exist between auditors and management, as this can lead to an overvaluation of assets that misleads investors.

Although Barnes is aware that current events in the City of London call into question the basis on which the regulatory regime operates, it is clear that the book was largely written before the chain of events that began with the collapse of Northern Rock in 2007.

There is no indication here that principles-based regulation as practised by the Financial Services Authority is in danger. As a consequence, one is led to speculate on the value of books written on subjects that are rapidly overtaken by events, no matter the expertise of the author. Will this book prove to be an epitaph for that regime?

Stock Market Efficiency, Insider Dealing and Market Abuse

By Paul Barnes

Gower Publishing, 224pp, £65.00

ISBN 9780566088490

Published 28 February 2009

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