Market Cleanliness

According to the "Efficient Market Hypothesis", a stock market is most efficient when insider traders fail to make any profit. Then obviously the modern stock markets are still far behind from this kind of "strong form" efficiency.

FSA recently published the results of its latest work to measure the "cleanliness" of UK financial markets. The market cleanliness measure is the ratio of informed price movements to significant announcements. The methodology measures market cleanliness by looking at the extent to which share prices move ahead of the regulatory announcements that companies make to the market.

The research covered two types of market announcements:

• regulatory disclosures about the trading performance of FTSE 350 companies in the periods 1998-2000; 2002/03; and 2004/05; and
• takeover announcements for listed companies made in 2000 and 2002-2005

In both types of announcement the researchers looked for abnormal price movements around the time of the disclosure which would indicate the possible availability of information that may be of use to an insider trader. They then looked for the cases where these "significant announcements" were preceded by an apparent IPM that could suggest informed trading had occurred.

The analysis was also extended to examine the behaviour of trading volumes ahead of announcements and how changes in the sample could affect the measure over time.

The results show that in 2004/05 there was a significant decrease in the level of possible informed trading ahead of FTSE 350 companies' trading announcements, with only 2% of significant announcements being preceded by informed price movements compared to 11.1% in the period 2002/03 and 19.6% in 1998-2000.

For takeover announcements there was a decrease in the level of possible informed trading ahead of takeover announcements from 32.4% in 2004 to 23.7% in 2005. But the level still remains high and little changed from the situation in 2000 of 24% before the implementation of the FSMA.

Although a useful statistical study, it is important to recognise that the scope of the review does have some limitations. First, given the data and techniques at its disposal it focused only on insider trading – which is just one form of market abuse. Second, it only considered "cash" equities, rather than derivative or other instruments.