THE SEC, INSIDER TRADING & CRYPTO: WHAT YOU NEED TO KNOW

 

Are crypto traders covered by SEC insider trading rules against front-running?

 

 

INTRODUCTION

Insider trading can be legal or illegal.

Illegal insider trading is the trading of a company's stocks or other securities by people with access to material, confidential, non-public information about the company. Taking advantage of this privileged access is considered a breach of the individual's fiduciary duty.

In Part 1 of this series on insider trading, we discussed frequently asked questions about the investigation and prosecution of insider trading under federal law. Insider Trading FAQ Part 1.

In Part 2, we discuss the law enforcement agency responsible for monitoring illegal insider trading, the Securities and Exchange Commission (SEC). We also look at the SEC's role in regulating cryptocurrency, including insider trading or front-running.

Are crypto traders covered by SEC insider trading rules against front-running? They use material non-public information about pending crypto transactions to profit before a transaction is publicly confirmed. The SEC has not said if front-running crypto will lead to insider trading or other charges.

WHAT IS THE SEC?

The Securities And Exchange Commission was created in 1934 to help restore investor confidence in the wake of the 1929 stock market crash.

Congress created the SEC. When the stock market crashed in October 1929, public confidence in the US financial markets also crashed.

The SEC monitors and regulates compliance with the securities laws and ensures that companies selling securities to the public tell the truth about their business, the securities they are selling, and the risks involved in investing in those securities.

WHAT DOES THE SEC DO?

To protect investors, the SEC enforces federal securities laws, takes action against wrongdoers, and oversees the securities markets to ensure that investors receive fair and honest treatment.

DOES THE SEC PROHIBIT INSIDER TRADING?

The SEC enforces compliance with all securities laws passed by Congress, including laws prohibiting insider trading. Moreover, Rule 10b-5 prohibits corporate officers and directors or other insider employees from using confidential corporate information to reap a profit (or avoid a loss) by trading in a company's stock. This rule also prohibits the "tipping" of confidential corporate information to third parties.

WHY IS INSIDER TRADING ILLEGAL?

Trading based on material non-public information is illegal because it can create an unfair advantage for people who have access to inside information to the detriment of those who do not enjoy such access. If insider trading goes unpunished, ordinary people will be discouraged from participating in the financial markets. That lack of participation, in turn, will make it more difficult for companies to raise capital. Finally, the law seeks to discourage insiders from taking advantage of their trusted position by using information they obtained as an insider for personal advantage.

WHO DOES THE SEC CONSIDER AN INSIDER FOR INSIDER TRADING PURPOSES?

The SEC considers an insider a person or company that owns more than 10% of a publicly-traded company's voting shares. The formal SEC definition of an insider is a "director, senior officer, or any person or entity of a company that beneficially owns more than 10% of a company's voting shares."

In a nutshell, an insider is someone who has either (a) access to valuable non-public information about a company or (b) ownership of more than 10% of a company's equity, including directors and high-level executives. In addition, for criminal legal purposes, insiders also include people with access to material non-public information about a company.

WHAT IS THE PRIMARY METHOD THAT THE SEC USES TO IDENTIFY ILLEGAL INSIDER TRADING?

The primary method that the SEC uses to identify illegal insider trading is market surveillance.

The SEC uses sophisticated tools to detect illegal insider trading, especially around the time of important events such as earnings reports and critical corporate developments. Market surveillance activities are one of the primary methods that the SEC uses to identify illegal insider trading.

The SEC detects insider trading also by encouraging whistleblowers to come forward. Whistleblowers are often employees of the company or employees of the company's suppliers, clients, or service providers. Whistleblowers have incentives to come forward under the law by receiving 10% to 30% of the fines collected from successful insider trading prosecutions.

WHAT ARE RED FLAGS FOR INSIDER TRADING?

The SEC closely monitors the red flags for insider trading. There are specific red flags for insider trading, indicating possibly illegal insider trading activity.

For example, a red flag for insider trading is an insider's abnormal trading pattern, going from inactivity to trading, or from buying and selling to abruptly aggressively buying or selling a significant position in the stock.

The SEC can monitor illegal insider trading by looking at the trading volumes of any particular stock. Volumes commonly increase after material news goes public. However, if trading volumes rise dramatically without any public news to support such trading patterns, the SEC can flag those transactions for further scrutiny. The SEC then investigates to determine the persons involved in the unusual trading and whether or not material non-public information played a role.

The SEC takes its role to maintain a fair marketplace for all very seriously, believing that anyone trading based access to inside information would have an unfair advantage over investors lacking the same information.

HOW IS INSIDER TRADING PREVENTED?

Companies and regulators try to prevent insider trading to ensure the integrity of the markets. The SEC enforces the rules, encourages compliance, and educates people participating in the market. The SEC's role includes raising the public's awareness about insider trading.

Companies also play a part in preventing insider trading. Companies can implement programs to educate employees about avoiding insider trading or sharing material non-public information.

For example, employees need to learn what is material and what is considered non-public, in addition to learning not to disclose information related to earnings, takeovers, security offerings, or litigation to outsiders. Companies can also encourage employees to promptly report insider trading, unlawful disclosure, or market abuse concerns.

IS FRONT-RUNNING INSIDER TRADING?

Yes, front-running is insider trading, and it is illegal except in some limited cases. Front-running is a form of trading based on inside information.

Front-running refers to the illegal practice of purchasing shares based on advance non-public information that an upcoming transaction will materially affect the price of those securities. On its face, the person trading in this manner does so based on material non-public information, which is at the heart of illegal insider trading.

Front-running generally is just another form of market manipulation and insider trading. A person who engages in front-running anticipates price movements in the price of securities based on non-public information.

*Pro-Tip: Some forms of front-running, like index front-running, are not illegal.

 

SOURCE: https://cdn.corporatefinanceinstitute.com

EXAMPLES OF FRONT RUNNING

The Corporate Finance Institute has published these three examples of front-running practices that occur in the industry.

First, the classic example of front running involves people trading because they anticipate large future transactions that will impact share prices. This form of front running typically occurs at brokerage firms.

A broker receives an order from a client to purchase 100,000 shares in a company. The broker knows that the purchase is significant enough to drive up the price of the company's stock. The broker decides to purchase personally 3,000 shares in the same company before executing the client's order.

The broker buys 3,000 shares at $10 per share before putting the client's order through. The client's order is so large that the share price jumps to $13 per share. Now the broker can sell at $13 per share, immediately realizing a $9,000 profit. The broker's conduct breaches the fiduciary duties owed to the client. The broker's conduct is unethical and illegal.

 A second example of front-running is when a person executes a trade while holding non-public information about an upcoming event that will materially affect share prices once the public learns about it. A classic example is when an analyst prepares an investment recommendation report about a company, recommending that clients buy that company's stock. The report has not been made public or even sent to clients.

The analyst buys the company's stock before the report becomes available to the public. The analyst expects the share price to go up once his recommendation is published, making a profit after the stock price increases. This conduct is insider trading and is illegal.

 A third example of front-running is called "index front-running," which is an acceptable trading strategy that is not illegal.

Index funds shadow the market indices, and they always learn about a new company being added to a market index before the company is actually added. Everyone knows that when a new company is added to an index, index funds will be purchasing a large volume of shares in the newly-added company.

If high-frequency traders, or HFTs, purchase shares in the newly-added company before the index funds, they will benefit from the share price increase once the index funds make their large buys. The index funds' large orders immediately push up the share price. Therefore, high-frequency traders can profit from front-running the index funds without violating insider trading rules.

*Pro-Tip: What is an HFT firm? An HFT firm is a company that uses a high-frequency trading strategy. High-frequency trading, also known as HFT, is a method of trading using robust computer programs to place a large number of orders in fractions of a second. Tower Research, Citadel, and Virtu Financial are some of the best-known firms specializing in high-frequency trading strategies.

FRONT-RUNNING AND CRYPTOCURRENCY

In the crypto world, front-running is trading cryptocurrencies based on publicly unavailable information about a future transaction.

Cryptocurrency trading experts explain the problem as follows: with front-running, crypto traders use non-public information like pending transactions to maximize profits before a crypto transaction can be confirmed and becomes publicly known.

Global blockchain experts anticipate the problem of front running when it comes to cryptocurrencies to continue to grow. That's because there is a period when some people have access to inside information about a future crypto transaction. Since there is always a time delay before a blockchain transaction is done, some people with information about it can exploit the time lag to book their own crypto transaction and earn profits based on inside information.

 

Is front-running illegal insider trading activity under these facts? Time will tell whether federal regulators will investigate or charge people participating in this type of crypto transaction with illegal insider trading.

WHICH FEDERAL AGENCIES REGULATE CRYPTOCURRENCIES?

The SEC, the CFTC (Commodities Trading and Futures Commission), and the IRS (Internal Revenue Service) each regulate certain aspects of cryptocurrencies. The power to regulate cryptocurrencies does not appear to sit with one federal agency alone.

It is no secret that governments around the world are in unchartered territory when it comes to laws and policies for regulating crypto. Many proposals for cracking down on illegal activity in a cryptocurrency environment are under consideration.

For now, in the US, cryptocurrencies fall under the jurisdiction of the SEC for investment issues, the CTFC for any crimes involving interstate commerce, and the IRS for taxation issues.

The SEC recently approved the trading of crypto on specific exchanges.

The SEC recently approved one Bitcoin futures Exchange Traded Fund backed by Bitcoin. No other futures ETFs have been issued at this time, although many applications are on file.

The most regulatory power the SEC currently holds in the crypto space is over ICOs. It recently halted an ICO after learning of fraudulent transactions. Some ICOs have yielded massive returns for investors. Numerous others have turned out to be fraud or have failed or performed poorly.

*Pro-Tip: An initial coin offering (ICO) is the cryptocurrency industry's equivalent to an initial public offering (IPO). A company looking to raise money to create a new coin, app, or service launches an ICO as a way to raise funds. Interested investors can buy into the offering and receive a new cryptocurrency token issued by the company.

Although ICOs are not regulated, the SEC can intervene in court when necessary to prevent wrongdoing. The SEC did so when the maker of Telegram raised $1.7 billion in an ICO in 2018 and 2019. The SEC filed an emergency action and obtained a temporary restraining order due to illegal activity by the development team. A federal court agreed with the SEC and issued a preliminary injunction. Telegram had to return $1.2 billion to investors and pay a civil penalty of $18.5 million.

For its part, the CTFC recently subpoenaed major crypto exchanges Bitfinex and Tether in order to verify whether Tether had adequate reserves (over $2.3 billion).

Cryptocurrency activity and speculation continue unabated. Can the federal government effectively regulate Bitcoin, Ethereum, and other crypto alternatives in this period of rapid growth in cryptocurrency trading and investing?

Stay tuned. The federal government will likely increase the effort to regulate cryptocurrencies as high speculation and artificial pricing continue to persist. In addition, whistleblowers will play a key role in addressing criminal activity in the crypto world.

CONCLUSION

Front-running is a form of trading based on inside information that can be subject to prosecution under federal law. Are crypto traders covered by SEC insider trading rules against illegal front-running? Often, crypto traders have access to material non-public information about pending crypto transactions, and they trade on it profit before a blockchain transaction is publicly confirmed. The SEC has not said if front-running crypto trades in this manner will lead to insider trading or other charges.

The cryptocurrency market continues to attract fraudulent activity. For now, the SEC and the CFTC have stepped in to address fraudulent activity and other enforcement issues with cryptocurrency. As always, the SEC, the CFTC, and other law enforcement agents will seek to get information about any illegal activity with the help of whistleblowers.