Market Manipulation And Innovation

Douglas J. Cumming

York University – Schulich School of Business

Shan Ji

Capital Markets CRC

Rejo Peter

York University – Schulich School of Business

March 20, 2016

Abstract:

We study the impact of suspected market manipulation, including end-of-day manipulation and insider trading around information leakage events, on patents based on a sample of 9 countries spanning the years 2003-2010. The data indicate that end-of-day dislocation mitigates the number of patents and citations received, due to the associated short-termism of the firm’s orientation, long-term harm to a firm’s equity values, and commensurate reduced incentives for employees to innovate. Unlike prior literature that shows a negative relation between patenting and liquidity in the U.S. in an earlier time period, we observe a robust and significantly positive effect of liquidity on patenting in the U.S. and across the 9 countries in our sample over each of the 8 years studied. The positive effect of liquidity on innovation, however, is mitigated by the harmful presence of end-of-day dislocation. The data also confirm the importance of country-level factors such as intellectual property rights across countries that encourage patenting. Our findings are robust to numerous robustness checks on subsamples of the data, propensity score matching analyses, difference-in-differences tests for firms with and without dislocation, among other things.

Market Manipulation And Innovation – Introduction

Pretty much without exception, financial market misconduct is viewed as being very costly to financial markets, and hence is an active area of scholarly study. Research on the consequences of financial market misconduct can be categorized into four types of papers: (1) managerial consequences such as salaries, termination, and jail terms (Karpoff et al., 2008a; Bereskin et al., 2014; Aharony et al., 2015), (2) stock market participation at the country level (La Porta at el., 1997, 1998, 2002, 2006) and individual level (Giannetti and Wang, 2014), (3) consequences in terms funds under management such as for hedge funds (Bollen and Pool, 2009) and mutual funds (Chapman et al., 2013), and (4) share price declines and legal penalties (Karpoff et al., 2008b; Karpoff and Lou, 2010; Dyck et al., 2010, 2014; Vismara et al., 2015). In this paper, we extend this line of literature by examining a fifth category not previously studied in the literature: the effect of financial market misconduct on innovation. We examine whether there is a link between financial market misconduct and firm patenting in a number of countries around the world.

Financial market misconduct comes in a variety of forms. Two of the most commonly observed (and hence commonly studied) forms of manipulation include insider trading (Allen and Gale, 1992; Allen and Gorton, 1992; Meulbrook, 1992; Bebchuk and Fershtman, 1994; Agrawal and Cooper, 2015; Bernilie et al., 2015; Aitken et al., 2015b) and end-of-day manipulation (Comerton-Forde and Rydge, 2006; Comerton-Forde and Putnins, 2011, 2014; Atanasov et al., 2015; Aitken et al., 2015a). It is well known that when there is information only known by insiders then insiders can trade in advance of public dissemination of the information for short-term profit at the expense of the counterparties in the trade and at the expense of the long-term value to the firm. It is perhaps somewhat less well known that there are massive incentives to manipulate closing price by ramping up end of day trading to push the closing price to an artificial level. End-of-day prices are used to determine the expiration value of derivative instruments and directors’ options, price of seasoned equity issues, evaluate broker performance, compute net asset values of mutual funds, and compute stock indices (Comerton-Forde and Putnins, 2011, 2014).

Market manipulation

In theory, there are different perspectives on whether or not market manipulation should enhance or mitigate innovation. On one hand, the presence of market manipulation is associated short-termism of the firm’s orientation which is inconsistent with a long-term managerial focus on innovation. Also, market manipulation imposes long-term harm to a firm’s equity values, and commensurate reduced incentives for employees to innovate. On the other hand, manipulation may enhance the gains to insiders from innovation, which would in turn increase the incentives for managers to innovate. In net, therefore, predictions on a link between market manipulation and innovation are ambiguous in theory, and one must therefore look to data to ascertain the validity of a connection between manipulation and innovation.

In this paper, we empirically study the link between market manipulation and innovation by assembling a sample of 131,129 firm-year observations across 9 countries (Australia, Canada, China, India, Japan, New Zealand, Singapore, Sweden, and the United States) spanning the years 2003-2010. It is widely regarded that insider trading is hard to prove as trading before information announcements may be attributable to market anticipation. Similarly, end-of-day dislocation may not always be attributable to manipulation and instead arise through unusual volatility and end-of-day market activity. Our empirical measures of insider trading and end-of-day manipulation are based on surveillance data of suspected insider trading and suspected end-of- day dislocation derived from alerts (computer algorithms that send messages to surveillance authorities). The advantages of these measures are that they avoid delays in enforcement, and that they are uniform without bias from differences in enforcement across firms and countries and over time. Also, suspected problems with a firm can be equally harmful to a firm as litigated problems in respect of focusing management on short-termism, hurting equity values, and diverting attention away from innovative activities.

Market manipulation

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