Friday, November 13, 2009

More on The Case for Insider Trading: Legalize It!

Suppose, for example, that shares of Acme Inc. are now selling for $50 per. Suppose also that an insider knows that Acme’s CEO and CFO have been cooking Acme’s books to make Acme appear to the public to be more profitable than it really is. If that insider can trade on that non-public information — obviously, by shorting Acme stock — the price of Acme stock will start to fall immediately upon the commencement of such insider trading.

Any trader who buys Acme stock after this insider trading commences gets a ‘fairer’ price — a more truthful price — than that trader would have gotten if Acme’s shares were still trading at $50 due to the fact that information about Acme’s true financial state remained private and unincorporated into Acme’s share price.

To the extent that insider trading causes prices to reflect asset values more quickly and more accurately, general investors should be more confident in asset markets and, hence, more likely to invest their earnings in such markets.


From
Don Boudreaux at Cafe Hayek, following up on his WSJ article "Learning to Love Insider Trading."

16 Comments:

At 11/13/2009 12:18 PM, Blogger Stan said...

I'm not sure the tradeoff is optimal. Yes, prices would move more quickly to their real value. But a lot of investors would view the trading as the cheating it is, and lose confidence in the markets.

The optimum solution is for insiders to reveal the fraud to the public immediately. Allowing them to benefit from the fraud on the grounds that their screwing of others has greater societal benefit seems to be settling for a "solution" which is inferior and beset by its own problems.

 
At 11/13/2009 12:58 PM, Blogger James Fraasch said...

The only way this works is if there is strict enforcement (fines and jail time) for those involved in cooking the books.

You cannot allow insider trading unless you have strict penalties for insiders who would otherwise take advantage of the ability to trade inside.

Other than that, doesn't seem like so far fetched an idea.

 
At 11/13/2009 1:20 PM, Anonymous gettingrational said...

Scenario: I 100 shares of Megacorp at $50.00 a share today. This decision is based on reading the financials of the company and favorable forecasts from management. A management insider sells 100 shares before the close of today's market session at $50.00.

This weekend it is reported that sales previously booked were sales to an off-book subsidary. The insider knew that a blogger was about to reveal this scam. On Monday the stock price plummets to $5.00 a share. Why shouold the insider benefit and I suffer a large financial setback?

The market needs to be a market not a beneficial insider trading society.

 
At 11/13/2009 1:21 PM, Anonymous gettingrational said...

correction: I buy 100 shares ...

 
At 11/13/2009 2:57 PM, Blogger OA said...

My only concern on insider trading is false rumors coming from inside to move stocks the other way. Much of the stock market beat down was due to that kind of manipulation. Bond traders were intentionally trying to take down financial company's stocks because stock price is actually a component of bond ratings for financial firms. Then the bond rating change would take the stock down and rumor became reality.

Actual trading I'm fine with since people do actually do watch option activity and trading volume. Almost no major news comes out without prior option market or stock market tells.

 
At 11/13/2009 2:58 PM, Anonymous Benny "Tell It LIke It Is Man" Cole said...

People invest based on trust. Capitalism survives on trust, and contract law.

If management too obviously starts cutting deals for itself, woe is us.

It is true, the compensation committees of boards of public companies should be much more active, and they could devise their own contracts, forbidding insider trading, or rigging pay to long-term results. But compensation committees seem to be buddies of the CEO, in most cases. That is the fault of institutional shareholders who show an amazing capacity to be inactive.

Actually, overall, I think being a shareholder has become the chump's lot.

If the investing public begins to think this, then investable capital shrinks. Not good.

 
At 11/13/2009 3:24 PM, Anonymous Anonymous said...

If insider trading were legalized change the name from the New York Stock Exchange to the New York Super Casino, for that is what it will be. At that point unless you can buy shares in the house you will loose. Its now awefully close to going back to the 1920's casino that lead to the great crash.
Actually we need a Tobin Tax (in the Old days stamp tax) of 10 basis points .1% on all trades that are not demoninated in dollars on all markets. If you are doing buy and hold you won't notice it, but if you are a trader you pay, and a day trader pays a lot which they should since they don't serve a useful purpose. Then take the long terms gains period to 5 years, again encouraging buy and hold, allow significant (1%) shareholders for a year to nominate board members, and make the pay packages for the CEO, top 5 and top 25 subject to share holder votes. Some say that a group of activists would propose directors that would run the company down, but if a majority of the owners want to run a company into a ditch isn't that their right as owners? (Actually since most companies are more owned by institutions, if they voted for board members who endorsed running into the ditch, they would be sued as not doing their duty to their holders, so its not realistic anyway.

 
At 11/13/2009 5:16 PM, Blogger PeakTrader said...

For every winner there's a loser. It's a trading market (of buyers and sellers). If insiders win (because of sure bets), guess who the losers will be.

 
At 11/13/2009 5:49 PM, Blogger Size said...

A management insider sells 100 shares before the close of today's market session at $50.00.

You'll never get a conviction. Here's why: if the guy was trading on material non-public information, then he would do much larger size than some piddly 100 shares. It's just not even worth investigating. The insider wouldn't do it from his own account anyway and 100 shares won't even show up on the radar.

If he tries to execute a size order to really take advantage of the information (and they always do), the unusually large size of the order will tip everyone off that somebody either knows or thinks he knows something and everyone will readjust their fair value calculation of the stock right away.

 
At 11/13/2009 5:55 PM, Blogger Size said...

My only concern on insider trading is false rumors coming from inside to move stocks the other way. Much of the stock market beat down was due to that kind of manipulation. Bond traders were intentionally trying to take down financial company's stocks because stock price is actually a component of bond ratings for financial firms. Then the bond rating change would take the stock down and rumor became reality.

I think you need to re-examine your conspiracy theory.

When everyone is panicking, rumours run rampant. Rumours are pretty rampant on the Street anyway, but they get really wild during a panic. Random musings on a trading desk are overheard and passed along and end up God knows where as a rumour. It's impossible to tell what's true and what isn't. But, your conspiracy is pretty hard to pull off.

If I get a call from another trading desk purposely trying to mislead me by a rumour they concocted, I'm going to be immediately suspicious about why they're sharing information with me. Most of the time, the originating desk begins panicking about something and acts on their panic. That makes everyone think they know something. Hell, a large order resulting from a forced liquidation to meet a margin call would have the same effect and the musing which turn into rumours begin.

You can't stop rumours. It's just impossible.

 
At 11/13/2009 6:02 PM, Blogger Size said...

For every winner there's a loser. It's a trading market (of buyers and sellers). If insiders win (because of sure bets), guess who the losers will be.

The guy too dumb to realize he's trading against an insider.

BTW, insider trading happens all the time now and nobody has lost confidence.

Do you even realize that politicians are NOT prohibited from trading on inside information. The same politicians that have masses of material non-public information about companies they drag before them, regulate and grant subsidy to. So, you can rail against company management all you want, but your congressman is entering trades based on material inside information all the time and with impunity.

Because of this exemption from them and because people refuse to learn basic trading skills before the confidently jump into the market, the average politician's stock portfolio outperforms the market by a whopping 25%. I would attribute it to brilliance if it wasn't the average of all of congress and if I thought these people were smart enough to get a real job, let alone smart enough to outperform the market.

 
At 11/13/2009 6:57 PM, Anonymous Strada said...

Where did this guy take his finance course, U-Mich Flint?

In order to cause a price movement on a stock, the insider would have to sell a huge volume of shares short and would probably have to do so highly leveraged. Naked short selling was banned. To sell, he'd have to find buyers who are completely clueless and then release the material nonpublic information in such a manner that it would erode stock prices fast enough to beat the margin call. The fraudulent information, meanwhile, would be countered by the crooks and full discovery could take months or years even with subpoenas. By that time, the insider is broke.

Every firm plays fast and loose with accounting, which is why analysts are paid to analyze financial statements for irregularities.

The downside of short selling is infinite downside. The stocks can remain elevated longer than you can remain solvent.

Move along, nothing to see here.

 
At 11/13/2009 7:27 PM, Blogger Michael said...

"To the extent that insider trading causes prices to reflect asset values more quickly and more accurately, general investors should be more confident in asset markets and, hence, more likely to invest their earnings in such markets."

I see a big flaw here. I don't know how close a fund manager is going to watch for this movement. This creates the problem of being in the "right" fund. I know have a new reason not to be in the market.

 
At 11/13/2009 7:32 PM, Blogger Methinks said...

Strada,

He doesn't need to sell naked anything. He could sell his long position. Also, it's not hard to locate massive amounts of easy to borrow stock. Locating is generally only an issue for small company shares with low floats.

But, usually, insiders don't short stock.

Usually, the insider who thinks he has information that will make the stock tank will buy puts. This maximizes his leverage and protects him from what you describe - the infinite risk of a short position. The options market maker who wrote the insider the puts will short the stock to hedge his short put position. Most insider activity shows up in the options market first.

 
At 11/14/2009 12:58 AM, Blogger OA said...

Size said...
... I think you need to re-examine your conspiracy theory.

You're comparing general rumors in the market to rumors from insiders. Presumably rumors straight from the source would be more credible. Just ask Raj Rajaratnam.

Whatever goes on now is no reflection on what would happen if insider trading were allowed. Insiders would collude to spike or tank stocks, buy options pretty far out of the money, then everyone would suddenly release a stream of rumors to various sources.

You could even do it without collusion. If you were someone in a credible enough position, you just make something up, spread it within the company and let the insider trading and leaks make it work for your trade.

 
At 11/17/2009 1:36 PM, Blogger Methinks said...

OA,

You're comparing general rumors in the market to rumors from insiders. Presumably rumors straight from the source would be more credible. Just ask Raj Rajaratnam.

Well, Raj actively sought out inside information. That doesn't mean the information he received was accurate or, indeed, even material, but it's not the kind of rumour you're talking about. BTW, Raj was a net loser on his insider trades. That's going to make it difficult to convict him of insider trading since it's only illegal to trade on MATERIAL inside information and it's not difficult to argue that if he lost on his trades, the information he was trading on was not material. That's more of an aside, but it does illustrate how difficult that rule really is.

Insiders would collude to spike or tank stocks, buy options pretty far out of the money, then everyone would suddenly release a stream of rumors to various sources.

Well, that's quite a wild scenario you've painted. Yet, there were no insider trading rules at all until the 1960's and what you describe did not happen. First of all, to maximize their profit on insider trades, insiders don't want to collude at all. They gain nothing from colluding with others but they lose a portion of their profit if they do. Second, if a buyer suddenly materializes for my rarely traded teeny options, as you describe, I'll take my market up so hard and fast on him that he won't want to trade. Do you honestly think people don't pay attention to order size and flow and the information it provides?

As for streams of rumours....we have constant streams of rumours on trading floors and desks. This is nothing new.

The insider trading rule accomplishes nothing but pile on costs.

 

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