The effects of shadow trading

You are a high-level insider at Pfizer, and at the beginning of November 2020, you learn that your company is about to launch a vaccine that exceeds all expectations and might soon put an end to the COVID-19 emergency. You immediately realize that thanks to the vaccine lockdowns will soon be over, and therefore people will spend less time on Netflix or using Zoom. Thus, you anticipate that upon Pfizer's announcement of its vaccine development, Netflix and Zoom stocks will go down in price. Can you profit from this inside information by shorting the stocks of Netflix and Zoom? In United States the answer is yes (Note that in Europe the answer would be resounding no, so don't try this at home!).

Corporate insiders engage in "shadow trading" when they use inside information about their firm (e.g., Pfizer) to trade shares of other companies (e.g., Netflix and Zoom). In a pair of forthcoming articles, my co-authors – Yoon-Ho Alex Lee at Northwestern University's Pritzker School of Law and Lawrence Liu at the University of Southern California – and I analyze the phenomenon of shadow trading. In the first paper, we study the effects of shadow trading on corporate investment choices and in the second, we focus on its macroeconomic consequences.

In our first paper, we develop a formal model to show that shadow trading can allow a firm to externalize part of the cost of its insiders' compensation on connected companies. The gist is that since insiders can profit from trading shares of connected companies, when they are permitted to do so by their firms' code of conduct, they are willing to accept lower salaries from their own company. Note that this is not necessarily bad news: allowing insiders to engage in shadow trading will increase their risk appetite, which can be beneficial to some extent for investors who hold diversified portfolios.

Consider a decision that you must make prior to our initial example: stay out of the vaccine race or make a huge investment. In the latter case, winning the race would bring enormous rewards to your company but losing would almost bankrupt it. If you can engage in shadow trading, the risky strategy of entering the race might sound appealing. If the project works, you will learn about it before the market, and hence you will be able to profit by shorting certain stocks, such as Zoom and Netflix. If the project does not work, you might get a lower performance-based compensation. On the other hand, you can make a handsome profit by shorting the stocks of other companies whose stock prices are expected to decline-such as those who participated in the investments. Note also that the insider stands to profit more if the potential swing in stock prices is greater. Thus, permitting shadow trading can increase insiders' risk appetite.

Further, we find that in some instances shadow trading might lead insiders and shareholders to prefer risky projects with negative expected values to profitable safe ones. This is because shareholders can profit in two ways from shadow trading when their firm invests in risky projects. First, they can have their corporation engaging in shadow trading. Second, as noted above, they can save on managers' compensation by negotiating lower salaries for their managers in return for permitting shadow trades.

As we discuss in our second paper, combining the model's results with the findings from the macroeconomic literature leads to the hypothesis that allowing shadow trading might have the effect of increasing the level of macroeconomic risk exposure. On the one hand, the macroeconomic literature has shown that a subset of "central" firms can impose large externalities on the economy and can trigger aggregate fluctuations in production (Gabaix 2011; Acemoglu et al. 2012). On the other hand, shocks at central firms also tend to have a larger impact on related companies' stock prices (Aobdia et al., 2014), and hence insiders of these firms can derive larger profits by creating risk and engaging in shadow trading. Put differently, the possibility of engaging in shadow trading gives insiders at firms with significant economic impact greater incentives to pursue risky investments.