Further on moral hazard

Yesterday, I talked about some possible ways to mitigate the issue of moral hazard in financial markets; however, either the way of giving more powers to participants on average or the way of improving the effectiveness of market monitoring cannot solve the problem completely.

Yesterdays’ solutions are more to do with organized illegal market activities. If we think that the market activities are all done by powerful organizations to merely serve their interests, then when all participants are powerful enough, they certainly do not have the incentive to conduct illegal market activities. Moreover, the number of powerful participants is relatively small, so it makes the market regulators easier to monitor their activities. However, in reality, it is fair to say that no market decision is solely made based on the organization’s individual interests. Any organization takes actions in the financial markets by hiring employees to represent them in the markets. Therefore, the conflict of interests between employees and their employers is a highly likely cause of moral hazard in the markets.

It is almost impossible for anyone to have perfectly matched interests with his/her employer; therefore, it is very possible for employees to have conflicting interests. When having conflicted interests, employees tend to choose to satisfy their own individual interests ahead of their employers’, when this happens, it is possible to lead to insider trading or other types of illegal market activities.

Using economics to understand the problem of inside trading, there is an equation to show the expected returns of insider trading:

Expected return = probability of not getting caught * benefits gained from successful insider trading – (1 – probability of not getting caught) * costs of getting caught

When the expected return is equal to zero, the two options for risk neutral people are indifferent, to look good, they may choose not to involve in insider trading, risk averse people will reject the idea of insider trading but risk lovers will choose to involve in insider trading.

As the benefits gained from successful insider trading is incredibly enormous, no matter how we increase the probability of getting caught or the costs of getting caught, there always are some risk lovers that are willing to take the risk and involve in insider trading. When our financial markets become more and more complicated, the probability of getting caught could be decreasing over time. The most effective way is to reduce the gap between the benefits from cheating and not cheating, in order to reduce the extra benefits gained from insider trading. However, it is impossible to erase insider trading completely.