What is Insider Trading - Key Insights and Implications

Despite the use of predictive models and advanced analytics, for the average investor investing in the share market, it is more or less a game of chance. Yes, you can make fundamentally sound decisions by investing in solid companies and sectors that seem to be booming, but even the most secure of stocks do have bearish periods where investors can lose money.

But what if you have confidential information that will likely drive up the stock price when it becomes common knowledge? You’ll be able to buy shares at their current price, wait for the news to be published, and watch the stock price soar. That is insider trading, and it is illegal. Let’s look at insider trading in detail, when it is legal, and its implications.

Insider Trading Meaning

Insider trading is defined as buying or selling the shares of a company with access to material, non-public financial data that could influence the stock price. Material data is any information that is significant and is likely to make an impact on an investor’s decision-making. While ‘insider’ can refer to any individual, be it employees, advisors, consultants or third-party contractors, in possession of unpublished, price-sensitive information (UPSI). Because the data is not accessible to the broader public, it makes them insiders and in breach of fair trading practices. The information enables them to profit off of market movements, giving them an unfair advantage over the general public.

For those who use tools like Margin Trading Facility (MTF) to amplify their investments, insider trading poses a significant risk to market fairness. It also highlights the importance of choosing the right partner when you open a Demat account to ensure compliance with regulation

Why is Insider Trading Considered Illegal?

Picture this: a small retail investor buys stock in a particular company through his share trading app. He does not know of the upcoming negative news that will tank the company’s share price. The news could be a product recall, quarterly losses, or even impending legal action against the company. Conversely, an insider who knows of this soon-to-be-public news sells his shares before it is published and avoids the potential losses. While its impact is seemingly personal, here’s how it affects the overall market:

Disrupting Market Liquidity: When insider trading occurs on a larger scale, the market can become less accessible, with fewer opportunities to buy or sell. It can also cause large price swings in the market at irregular times, defying market logic. This hinders the liquidity of the Indian share market, making online share trading more complex and expensive for regular investors.
Cycle of Corruption: Allowing insider trading can create a culture of dishonesty and greed, with people in positions of power manipulating the share market price for personal gain. This destroys any semblance of ethics and will ultimately hurt the very organizations they are exploiting, let alone other investors involved in share market trading.
Breaking Trust: Corporate insiders are expected to act in the best interest of the company and its shareholders. Using privileged information for personal profit is a clear violation of that trust. It affects overall share market investment sentiment, especially for individuals who invest in shares without access to such insider information.
Lowering Market Standards: If insider trading is allowed to continue unchecked, it can erode the overall standards of the market. Reputable companies may find it harder to raise capital, as investors lose faith in the fairness of the system. Meanwhile, weaker or less trustworthy companies might be able to stay afloat despite poor performance, leading to an unhealthy environment for investment in the share market.
Reputational Damage: When a company is involved in an insider trading scandal, its reputation suffers. This can lead to a loss of customers, investors, and business partners, making it harder to attract new share market investment or secure contracts. In the long run, such scandals can severely undermine a company’s prospects and future success, harming innocent shareholders who invest in the share market.

What Are the Types of Insider Trading in India?

There are multiple ways insider trading can be carried out in India:

Classic Insider Trading: As discussed above, this occurs when individuals make trades based on sensitive, non-public information to gain profit or avoid loss. What is insider trading in India? It’s governed by strict SEBI regulations aimed at maintaining fairness in the Indian share market.
Tipper-Tippee Trading: This involves an insider who has sensitive information (tipper) and an individual who receives the tip (tippee). If caught, both parties will be held liable for insider trading.
Blackout Trading: Listed companies have a trading policy wherein key management personnel and employees are prohibited from carrying out any trades during a specified period (blackout). Trading blackouts are usually imposed before earnings reports to minimize the risk of insider trading. Individuals who trade during this period will be held responsible for insider trading.
Misappropriation Trading: Trades resulting from stolen UPSI also fall under the ambit of insider trading.
Front-running vs. Insider Trading: Front-running mainly applies to brokers who execute trades for personal profit based on UPSI that will impact the share market. This is different from insider trading since it involves brokers front-running large orders instead of company insiders using information. Knowing the distinction between front running vs. insider trading is crucial for traders.

What Happens if You Get Caught Insider Trading?

Insider trading has severe legal consequences in addition to reputational damage:

Legal penalties include a fine ranging from ₹10 lakh to ₹25 crores, or thrice the profit made from the insider trades, whichever is higher.
Prison time: Guilty perpetrators can face up to 10 years in prison, depending on the severity of the crime.
Civil lawsuits: Other investors who’ve suffered losses can file lawsuits against the traders.
Market bans: Traders caught in insider trading NSE or BSE insider trading cases can be barred from participating in the share market.

One of the most infamous insider trading cases in the history of stock exchange in India was uncovered during the 2007 merger of Reliance Industries Limited (RIL) and Reliance Petroleum Limited. RIL was fined ₹447.27 crores plus interest and was prohibited from equity trading for a year.

How to Protect Yourself from Insider Trading?

The first step would entail a demat account opening online. Then avoid investing in a company whose employee has tipped you. When receiving a tip from your broker, inquire about the origin of the information. If you’re using a share market app or a share trading app, ensure it adheres to the Securities and Exchange Board of India’s (SEBI) guidelines. It’s also helpful to stay informed about the latest news related to insider trading NSE and BSE insider trading cases, as these can provide insight into how regulatory bodies are enforcing the law. A reliable share market app in India will have features that help users stay compliant with regulations.

Conclusion

When you open demat account online or through a share market app download, choose a reputed partner such as HDFC Sky. The same goes for any share trading app you use for online share trading. Whether you’re a beginner or a seasoned investor, playing by the rules ensures a level playing field and prevents volatility in the overall market. Insider trading goes far beyond individual impact and requires each investor to do their part in maintaining a fair and equitable investing environment. Understanding different types of trading and the legal implications of insider trading will help protect your investment in the share market and support a more transparent market system.