The existence of moral hazard is a serious problem in the financial markets in any country; in the developed countries, the governments have created very harsh laws and regulations to prevent moral hazard and punish the insider traders and any other market participant who breaks the laws and involve in the moral hazard activities. In the developing countries, the regulations and laws tackling the moral hazard are lacked, this is a reason that why in the developing countries the problem of moral hazard in their financial markets is much more significant. To reduce the existence of moral hazard I think is to reduce the benefits of making insider trading or other moral hazard activities as well as to increase the costs.
Firstly, to reduce the benefits of making insider trading, it is important to balance the powers of all market participants. There are two methods to balance the powers of all market participants: to lower all market participants’ powers or to lift up all market participants’ powers. The power in the financial markets involves several components: the efficiency of analyzing public information, the speed of accessing to public information, the access to people or parties who have private information, the power of manipulating market prices. However, it is impossible to make participants with different amounts of resources to have equal powers on these sectors. Large participants have more resources in all kinds: firstly, they have more elite employees with professional knowledge, so they are more likely to make better analysis on the markets; secondly, they have more funds, when more funds are injected into the market, they can influence the market prices; thirdly, they are large clients of other financial institutions, so they are more likely to know more people and have good relationships with people and parties who have private information; fourthly, they have more resources to spend on equipment to have early access to the public information as soon as the information is made public. It is impossible to divide large participants and make them smaller. Therefore, it is better to merge smaller participants and create several large groups and let them gain more power in the financial markets to narrow their power differences compared with those large traditional participants. As when all participants have the abilities to participate in the insider trading activities, the competition of benefiting from illegal trading activities is likely to be similar as the competition of benefiting from the legal activities, then the benefits from taking these activities will decrease due to the increased competitions, so considering the legal risk of taking illegal trading activities, it is better for every participant to follow the regulations and laws.
Secondly, to increase the costs of making insider trading, the most common and efficient way is to create more complete regulation system involving the legislative and judicial departments. When facing much more harsh penalties, the market participants will be less likely to involve in the insider trading activities. Moreover, these departments need more professionals who know how to track these illegal market activities. Maybe these departments should seek more help from the IT industry to develop software to monitor the market activities and look for possible illegal activities. In addition, it is also important to reduce the number of people and parties who are outside the financial sector but have private information or the abilities to have critical influences on the financial activities. When the number decreases, fewer are expected to participate in insider trading activities.
To conclude, I think that to reduce the existence of insider trading or other ill incentive market activities, it is important to have one independent department that monitors the market, makes critical market decisions; this can make the non-participants who have private information concentrated in one department and it is easier for the central judicial department to monitor the activities of this department. Moreover, small market participants should be encouraged to merge to form large groups to balance their power with other participants’ power in the market in order to reduce the expected benefits from insider trading.
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