Is trading by Congress illegal? Should members of Congress be allowed to trade financial securities that are sensitive to private information? The “coronavirus trades” made by Sen. Richard Burr (R-N.C.) and his wife just prior to the March ’20 market crash raise these questions and signal the need for changes to the law. Some proposals go as far as banning stock trading by members of congress outright. The other extreme is to allow full discretion. The right solution is in between: Only allowing public officials to trade securities based on broad market indices.
The concern over insider trading by members of Congress is not new. Academic research shows that investment strategies that mimic trades by members of the U.S. Senate and the House of Representatives outperform the market by more than 6 percent per year. Following an investigative report revealing congressional insider trading, the Stop Trading on Congressional Knowledge (STOCK) Act was passed almost unanimously by the Senate and the House in 2012.
While research suggests that abnormal profits earned by members diminished after the passage of the STOCK Act, there are also concerns that subsequent amendments to it increased the difficulty of policing insider trading by Congress. There is debate about the legality of the “coronavirus trades” made by members of Congress. But if their actions did abuse their privileged position, it may be challenging to prove that such actions are indeed illegal.
One fundamental problem in recognizing illegal insider trading is the lack of clarity in U.S. securities laws. The history of insider trading prosecution indicates that the boundaries of illegal insider trading are at best time variant, and at worst, blurred.
The obfuscation of insider trading laws is evident in a number of contradictory judicial rulings over the last decade or so, when the bar for the definition was constantly changed. In light of this ambiguity about the definition of insider trading, it is time to fix the law.
Fortunately, clear guidelines for new regulation have already been proposed by the former federal prosecutor Preet Bharara’s task force on insider trading. However, it is still not clear how this applies to members of Congress and other public officials.
Our proposed compromise to allow public officials to trade only securities based on broad market indices such as ETFs would alleviate issues that would appear in either extreme proposal. On the one hand, total prohibition of securities trading may deter qualified candidates from running for office altogether. On the other hand, allowing trading without close oversight damages the public trust. Since most privileged information that such officials receive is more likely to impact individual security prices than broad-based market indices, concerns over potential insider trading would be mitigated using our solution.
Financial research repeatedly points out that it is difficult to consistently beat the market . Legitimate outperformance is likely the result of luck or superior financial skill, the latter requiring focused attention to the markets. Trading would anyway distract elected officials from fulfilling the mandate of public office. Unethical or illegal outperformance would be due to access to privileged private information, which is precisely the transactions that should be banned.
The growth of the passive investment fund industry is a testament to the attractiveness of broad-based market strategies that are less sensitive to private information. In light of the diversity of mutual funds available, members of Congress would certainly not fall short of choices.
While our proposal would curb elected officials’ opportunity to “become lucky,” it would also eliminate their ability to abuse their power for private benefit. Further it would minimize the public costs of monitoring and policing the trading activities of public officials. Perhaps most importantly, it would help regain trust that has been lost.
Patrick Augustin is assistant professor of finance at the Desautels Faculty of Management at McGill University. Francis Cong is a researcher at the Desautels Faculty of Management at McGill University. Marti G. Subrahmanyam is Charles E. Merrill Professor of Finance and Economics at the Stern School of Business at New York University.