Sunday, October 25, 2009

Legalize It!

George Mason economist Don Boudreaux makes the case for legalizing (decriminalizing) insider trading, a potentially victimless "crime," in the Wall Street Journal. Here's an except:

Not only do insider-trading prohibitions slow economic growth, promote corporate mismanagement and discourage investment diversification, their application also is unavoidably biased.

These prohibitions are meant to prevent all insiders with non-public information from profiting from the use of such information before it becomes public. It follows that unbiased application of these prohibitions should target not only traders whose inside information prompts them to actively buy or sell assets, but also traders whose inside information prompts them not to make asset purchases or sales that they would have made were it not for their inside information.

The insider who learns that the Food and Drug Administration will approve a new blockbuster drug developed by a major drug company, for example, obviously profits from this information if it prompts him to buy 1,000 shares of the company that he otherwise wouldn't have bought. So, too, though, does the insider profit who, upon learning the same information, abandons her plans to sell 1,000 shares of the company. But because insider "nontrading" is undetectable, only the former insider is practically subject to prosecution and punishment.

And because opportunities to profit through insider "non-trading" might well occur with the same frequency as opportunities to profit through insider trading, as many as half of those investment decisions influenced by inside information might be undetectable.

This bias is not only a source of prosecutorial unfairness; its existence casts doubt on the assumption that insider trading is so harmful that it must be treated as a criminal offense. After all, if capital markets continue to function as well as they do given that many investment decisions potentially influenced by inside information are unstoppable because they are undetectable, why believe that the detectable portion of investment decisions influenced by inside information would be harmful if they were legal?


At 10/25/2009 11:05 AM, Blogger PeakTrader said...

Insider trading is harmful, because the stock market is a zero sum game. If the stock market rises 10% and someone makes 100%, e.g. on insider trading, then everyone else averages less than 10%.

At 10/25/2009 11:07 AM, Anonymous Anonymous said...

Oh, great, a new way to compensate executives and insiders!

This will make the market work--everyone will want to own stock so they can be a sucker.

People who profess to believe in markets are some of the ones bent on destroying them.

At 10/25/2009 11:31 AM, Blogger Unknown said...

Killing should not be illegal because the person was going to die anyway. Same logical argument for inside trading. Or is it an illogical argument?

At 10/25/2009 11:57 AM, Anonymous Anonymous said...

pretty clear from their comments that the other posters didn't actually read the piece.

the joy of punishing somebody for something seems to override thought.

At 10/25/2009 12:02 PM, Blogger PeakTrader said...

What would you call giving the answer of a test problem to one student, but not to the other students?

At 10/25/2009 12:32 PM, Anonymous gettingrational said...

Insider trading benefits those with huge amounts of capital. Why? Becuase smaller investors won't have the same knowledge that the big institutions will demand access to. The consumer, that Don Boudreaux claims to represent, is damaged financially from the lack of equal inside information for all investor classes.

At 10/25/2009 1:18 PM, Anonymous Anonymous said...

Manne and the others who criticise insider trading rules base their argument on disclosure of information (albeit benefiting insiders) increases market efficiency.

However, the information that is disclosed is not the property of the discloser. It is theft of corporate information.

A counter rule would be that corporations must have more complete and timely disclosure of all information.

Manne and his followers don't care about fairness either.

You should.

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At 10/25/2009 1:54 PM, Blogger OBloodyHell said...

I think the main thing would be making insider trading VISIBLE.

Suppose it worked like this:

You aren't allowed, as a GM exec, to buy or sell GM stock without it being public knowledge -- probably stock anywhere in the automotive industry & associated businesses where GM held substantial sway or information would be better -- then the transparency would be an adequate field leveling.

Then you could pay attention and do data analyses of the purchases/sales of various specialists in business.

At 10/25/2009 1:59 PM, Blogger Benjamin Cole said...

Not sure about this one.
Capital markets, in a free society, rely upon trust.
No sure I would trust the management of a company that could freely trade on inside information, or could leak inside information to favored parties. Why would I own stock in such a company. A few scandals, and investors pull out of the stock market, looking to bonds.
Indeed, would bankers and other lenders trust business borrowers who trade on inside information?
As a lender, I would wonder if management could leverage up, and short the company. Then they don't care too much if the company goes bust.
Anonymous put it best: Inside information belongs to the company, and it should be a formal company decision to disclose that information.
I still want to see the libertarian view on sidewalk vending.

At 10/25/2009 3:05 PM, Blogger juandos said...

Hmmm, legalize insider trading, eh?

Well why not?

I'm thinking about how quickly the particular market where insider trading has been allowed would collapse...

I mean who would want to touch that market other than the small handful of people with the inside info?

At 10/25/2009 3:49 PM, Blogger Tom Davis said...

@PeakTrader, generally, professors and other teachers give all of their students the answers to questions on tests (or at least the tools to figure them out).

@gettingrational, it is as true of other information sources as it is of insider information that those who have more invested tend to do more research and spend more of their resources to get information than do others. There's nothing special about insider information in this regard.

@Anonymous, if the insider information is theft of corporate secrets than the companies themselves would be suing for breach of trade-secrets and it would be civil rather than criminal proceedings.

At 10/25/2009 7:19 PM, Anonymous Steve said...

Why should insiders be allowed to profit on stock moves when the public would not be allowed to. I have never heard an argument for insider trading before and there's a good reason for it.

At 10/25/2009 8:13 PM, Anonymous DL said...

I favor the vigorous prosecution of those who engage in insider trading. It is most definitely not a “victimless” crime.

At the same time, I recognize that only a miniscule fraction of those who engage in it will ever be caught.

At 10/26/2009 7:58 AM, Blogger Braxton Hicks said...

I never really thought about "flipping" the issue of insider trading on it's head, but this is an interesting article. At first glance, I think the author has made a good point.

At 10/26/2009 8:13 AM, Blogger ExtremeHobo said...

If I could rate a post I would rate Tom Davis' as +5. Good points sir

At 10/26/2009 9:50 AM, Anonymous gettingrational said...

@ Tom Davis, My point was that to get favorable terms, from large captial sources, firms will have to divulge critical inside information. This is not more research but relenting to demand for information that is opaque to other investors. More time and research is given to the large capital source by the borrowing firm as a condition of financing.

At 10/26/2009 10:10 AM, Anonymous Anonymous said...

The beneficiaries of insider trading are those who can temporarily (or permanently) manipulate the performance of the company. If I am holding shares of stock and am in an influential position I can sell short my shares, execute harmful business decisions, tank the company for a month, and unfairly profit having acted in advance of my executed plan.

Similarly, sales executives could dump product in the market for a month, agreeing to take back any product that does not sell in future months (i.e., after the quarterly Analyst call), sell my shares at a profit, then take back all of the returns. This happened at a client of mine when I was an auditor.

Not to mention, unharnessed insider trading increases price volatility.

At 10/26/2009 10:22 AM, Anonymous morganovich said...


your zero sum argument is utterly nonsensical. you could make the same argument about anyone who owned a stock that outperformed the market.

the whole point of picking stocks is to outperform the market. shall we ban owning stocks that go up 100%? someone will own them unless we don't.

your notion that my owning a stock that goes up somehow hurts you is indefensible. how does it affect the value of your assets?

one could even argue that by making stocks go up sooner, insider trading is a net benefit as it lets you make your profits earlier and have the opportunity to re-invest them faster to participate in other opportunities.

the problem with current insider trading law is that it is very poorly defined and even more poorly enforced.

lots of markets around the world have no ban on insider trading. to my knowledge, it has caused no significant dislocations.

reg FD has been a miserable failure. it has not stopped the most egregious insider trading, but has made management teams far more careful about what they say in public or on private calls with investors they don't know well.

this has resulted in less overall information in the market and, ironically, more informational asymmetry that before. less information leads to less efficient pricing, which, again ironically, increases the incentives to insider trade.

i'm not going to defend galleon, as they were clearly breaking the law and aware that they were doing so, but as someone who spends his days seeking an "edge" on the market, i can tell you that it's a scary dance. you want as much information as you can get to make decisions. you want to talk to customers, distributors, industry analysts, and the like. but you need to be very careful not to come into possession of "material nonpublic information" which is a phrase so ill defined that no one could draw a precise line.

even the rules about who tells you are crazy. if the CFO of a company tells you they will miss the quarter, then you are clearly an insider. or are you? what if you didn't ask? is is reasonable for him to take you "over the wall" and prevent your trading in a stock without your prior consent?

weirder, if he tells his barber they are going to miss the Q and then the barber tells you, you are likely far enough removed that you are no longer legally an insider because they guy who told you is not an insider. this one degree halo effect is madness and obviously prone to dramatic abuse.

consider the position in which it places a sell side analyst.

most companies already have very strong rules about insider trading. officers and employees have windows in which they are allowed to trade, and large blackout period where they cannot,
but once the information goes outside, especially by more than 1 degree, the situation gets so nebulous as to have nearly unpredictable results in a prosecution.

this whole system needs to be rethought.

At 10/26/2009 6:26 PM, Blogger PeakTrader said...

Morgan, you don't understand. Everyone can't outperform the market, because everyone is the market. I stated:

"If the stock market rises 10% and someone makes 100%, e.g. on insider trading, then everyone else averages less than 10%."

The stock market is the sum of all investors. When one investor outperforms through cheating, then the rest of the investors underperform.

If there wasn't insider trading, then that capital would flow into other stocks, raising their prices, and the cheaters would make more of a normal return.

It's analogous to my subsequent statement: "Giving the answer of a test problem to one student, but not to the other students?"

The cheater will receive a better score. When grading on a curve, everyone else falls back a notch, except the students below the score the cheater would've got if he didn't cheat.

At 10/26/2009 8:38 PM, Blogger Mark J. Perry said...

PeakTrader, you don't understand. How do you distinguish between: a) better researchers and traders with inside information, and b) the average student and students who study harder?

"If the stock market rises 10% and someone makes 100%, e.g. on insider trading (BETTER RESEARCH), then everyone else averages less than 10%."

The stock market is the sum of all investors. When one investor outperforms through cheating (BETTER RESEARCH) then the rest of the investors underperform.

If there wasn't insider trading (BETTER RESEARCH), then that capital would flow into other stocks, raising their prices, and the cheaters (BETTER RESEARCHERS) would make more of a normal return.

It's analogous to my subsequent statement: "Giving the STUDY GUIDE TO ALL STUDENTS.”

The STUDENTS WHO STUDY HARDER will receive a better score. When grading on a curve, everyone else falls back a notch, except the students below the score the STUDENT WHO STUDIED HARDER would've got if he didn't STUDY SO HARD.

At 10/27/2009 2:17 AM, Anonymous Anonymous said...


Part of me wants to say make it legal as long as the big players disclose their moves. But I worked at BAC in IS supporting commercial banking in NYC. I had access to every field auditor's report before they reached the first level of management. I knew the fiscal situation each BAC customer was in before then general public. I could move before the market did.

If you make insider trading legal, the general public will move its money other markets and public companies will lose a major source of capital. I'm not going to put my money in a stock based hedge fund unless I know the guy running the fund has inside access to CEOs in the firms the hedge wants to invest in.

You keep using the phrase "BETTER RESEARCH". Inside information can't be better research by the simple fact it isn't public.

At 10/27/2009 2:23 AM, Anonymous Anonymous said...

It's analogous to my subsequent statement: "Giving the STUDY GUIDE TO ALL STUDENTS.”

But you're not. You are giving the STUDY GUIDE to a favored group of students. Read this and you get As while the rest of the class gets Ds.

Soon the student will catch on and not take classes from Mark Perry.

At 10/27/2009 3:18 AM, Blogger Robert Sperry said...

"What would you call giving the answer of a test problem to one student, but not to the other students?"

Tutoring. Which is one reason affluent schools do better. The parents of struggling kids buy them tutoring. Perhaps we should ban that as well as part of the solution to the education gap.

At 10/27/2009 2:58 PM, Blogger PeakTrader said...

Dr. Perry:

I distinguish the difference as one who wins on his ability and one who wins on handicapping his opponent.

Do we get rid of speed limits, because everyone who deserves a speeding ticket doesn't get one? The risk is there.

There are far fewer insider traders who won't sell their stock than there are insider traders who'll buy the stock. Why? Because cheaters also cheat themselves :), and wouldn't own the shares, or many shares, in the first place.


When you're sitting before a test in class and you're the only student, or one of the few "privileged" students, who knows what the question and answer will be, a tutor is unnecessary.

At 10/27/2009 3:16 PM, Blogger PeakTrader said...

Another way to look at it is imagine a race where one runner has to carry lots of research papers, financial statements, etc., another runner has to carry many textbooks, study guides, etc., while another runner doesn't have to carry anything.


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