Shadow trading and macroeconomic risk

“Shadow trading” occurs when a corporate insider uses sensitive inside information pertaining to her own firm to buy or sell shares of other companies whose stock price movements can be predicted given the information. These transactions are highly profitable but not systematically regulated, and there is evidence that they are a widespread phenomenon among corporate insiders. Unlike classical insider trading, shadow trading by a corporation’s insiders does not result in a direct harm to the corporation’s own shareholders, and to some extent, shareholders may even benefit from such transactions. In this Article, we argue nevertheless that shadow trading poses three issues: (i) it can create a moral hazard problem for corporate insiders, which can lead them to engage in excessive corporate risk-taking and to even invest in negative-expected-value projects; (ii) it can increase the level of macroeconomic risk to which the economy is exposed; and (iii) it can exacerbate the severity of economic crises. Our analysis thus offers novel rationales for regulating shadow trades. This Article concludes by suggesting a menu of possible policy reforms that can address the problems created by shadow trading.