Insider and stealth trading with dynamic legal risk

Abstract

The present paper investigates how insiders strategically navigate ongoing legal risk while leveraging stealth trading within a continuous-time Kyle-type framework. Legal enforcement operates concurrently with trading, which dynamic can be adversely obscured by a large surrounding population of noise traders. While surveillance intensity responds directly to the insider's trading intensity, triggering a random prosecution time, the resulting legal sanctions encompass both strategy-focused criminal penalties and profit-dependent civil penalties. Employing a new impact-neutral measure change, equilibrium analysis shows that even after achieving stealth, the insider internalizes regulatory exposure, and enforcement can significantly shape equilibrium trading strategies. The associated limiting equilibria yield a rich set of outcomes, with three key insights for regulatory impact: (i) under committed regulatory scrutiny, the insider trades a time-varying function of the discrepancy between the asset's fundamental value and its market price, and trading may intensify indefinitely near the end of the trading horizon as legal risk recedes; (ii) merely raising penalties as an advantageous selection cost proves ineffective in offsetting declines in regulatory diligence; (iii) criminal penalties remain essential for deterring aggressive insider trading, as they impose critical temporal constraints on trading intensity not achievable through civil penalties alone.