When is public enforcement of insider trading regulations effective?

In this paper we investigate when public enforcement of insider trading regulations reduces the amount of insider trading. We model a game between a potentially self-interested regulator enforcing insider trading laws and a trader who may be trading on inside information. We show that equilibrium strategies exist where despite active enforcement all inside information is used. Furthermore, we find that increased disclosure in order to reduce the amount of inside information does not necessarily lead to less insider trading as insiders may more frequently use their information. Increased disclosure decreases the contribution of public enforcement to reducing insider trading. We also show that improvements in the risk analysis system used by the regulator for monitoring purposes may prompt more insider trading. The results yield policy implications, contribute to explaining empirical observations, and suggest possible directions for future empirical research into the relationship between enforcement and the cost of equity. © 2012 Elsevier Inc. All rights reserved.