Is It Wrong to Capitalize on Nonpublic Fed Information?

Perhaps the most well-known aspect of securities law is the illegality of insider trading. If a person gains access to nonpublic information about a firm, it cannot be used as a basis for buying or selling its stock. Yet, an interesting special report from Kristina Cooke, Pedro da Costa and Emily Flitter at Reuters reveals that the same rules don't apply to the Federal Reserve. Considering the importance monetary policy holds these days, shouldn't the same rules apply?

The authors of the Reuters article explain that some people with close ties to the Fed use their insider knowledge to their advantage. They provide the following example:

On August 19, just nine days after the U.S. central bank surprised financial markets by deciding to buy more bonds to support a flagging economy, former Fed governor Larry Meyer sent a note to clients of his consulting firm with a breakdown of the policy-setting meeting.

The minutes from that same gathering of the powerful Federal Open Market Committee, or FOMC, are made available to the public -- but only after a three-week lag. So Meyer's clients were provided with a glimpse into what the Fed was thinking well ahead of other investors.

His note cited the views of "most members" and "many members" as he detailed increasingly sharp divisions among the officials who determine the nation's monetary policy.

The inside scoop, which explained how rising mortgage prepayments had prompted renewed central bank action, was simply too detailed to have come from anywhere but the Fed.

According to the article, those with nonpublic knowledge of the Fed are not forbidden from using that information to their advantage. Indeed, Meyer charges clients $75,000 for his advisory product, who can then use the information as the basis for buying and selling securities. This raises two questions: shouldn't benefiting from such nonpublic Fed information be illegal, and if not shouldn't Fed officials be forbidden from disseminating such important information selectively?

Should It Be Illegal?

The insider trading law is pretty interesting, because it doesn't really say to whom you can and cannot provide information. Instead, it just says that anyone who possesses inside information can't benefit from it until it's released to the general public. Obviously, the law could have been written differently to more specifically ensure that secrets are kept that way.

This is really more of a practical point than a philosophical one. It's a lot easier to simply forbid those with nonpublic information from trading based on it than worrying about who knows nonpublic information -- it's easier to track trading than it is to track all information sharing. And besides, it's only when someone tries to profit from that information that it harms the market. So a company's management doesn't have to worry about sharing information with auditors or consultants. The burden is on those parties who learn the nonpublic information not to trade securities based on that knowledge.

Shouldn't there be a parallel here with the Federal Reserve? The article appears to say that if the Federal Reserve is on the verge of voting in favor of some drastic new monetary policy that would shock the market, and its secretary recording the minutes texts the information to his girlfriend who trades stocks based on it before it's released, then that's perfectly legal. Yet everyone knows that the Fed moves markets -- so how would that be okay?

Should Fed Officials Be Silent?

The problem here, however, is one of practicality. In other insider trading situations, it's easy to track. If you see some guy buying 100,000 shares of xyz stock just before its acquisition is announced, then you know pretty quickly that something fishy is going on.

But if someone has nonpublic information about an aggressive new qualitative easing program that the Fed has just decided to roll out, there's no single security that would show a clear intent to use this information. You could buy index securities or you could buy bank stocks. You could also buy certain derivatives or bonds to capitalize. There are numerous options. An investor could also more easily claim that the trading was based on some other information, since the securities it affects are non-specific. So it's almost impossible to police.

As a result, the only alternative here is the less perfect rule of forbidding information sharing. Fed officials or other employees with nonpublic information about the goings-on at the central bank must refrain from sharing what they know with outsiders. Although this is also hard to police, it's a little easier than trying to figure out who is trading based on nonpublic knowledge of the Fed. And of course, such rules could also act as a relatively effective deterrent. If Fed employees know they could get in trouble for sharing nonpublic information, then they'll almost certainly be less likely to do so.

While it's easy to understand why it would be hard to apply insider trading rules to the Fed, we should be concerned that those with nonpublic information on central bank policy are using it to their benefit. The central bank's policies regularly move markets, so it's pretty shocking that there aren't strict and serious rules in place to prevent its employees from selectively disseminating nonpublic information.