I recently rediscovered a short piece I had written about insider trading. It’s not particularly relevant to anything happening today, but insider trading continues to be a crime prosecuted by authorities and here I offer a couple of reasons it should not be.
The standard libertarian counterpoint to insider trading being a crime is to ask who the victim of insider trading is when, for example, an insider sells their stock before it is announced that a publicly traded company has gone bankrupt. The intuitive answer should be the people who bought the stocks from the person with insider information.
But this doesn’t hold up very well. Those people could have bought the stock the day before from someone else. They could have even been indifferent to when they bought the stock. If that’s true, then how could one person selling it be moral and another person selling it be immoral? The people who bought the stock the day before are just as screwed. The people who bought it the day before would be screwed even if there was no insider trading, since the company is bankrupt anyway in this example.
Someone dumping the stock adds information to the market. If insider trading was legal, you’d have investigatory firms that spend lots of money infiltrating into companies, and you’d probably find out about a company having trouble way before they file for bankruptcy. In the long run fewer people might be screwed over.
Yet don’t we prosecute other similar “insider” situations, like a scam where someone sells a lemon car to an unwitting customer?
This seems different. There is a clear victim if someone lies about their car before selling it. The victim of insider trading is hard to find. It’s not the person who bought the stock, since they put in an order without knowing about who was selling or not that day. They could have bought it from anyone, since stocks are commodified. The victim is all stockholders, collectively. Yet the vast majority of the cost borne by stockholders is due to the actual company being bankrupt. In fact, had the insider trading not occurred, everyone who bought stocks that day would have had to pay a bit extra for their stock, losing even more money. Thus, there’s an argument that insider trading is actually beneficial to the theoretical “victims”, a very odd criminal justice situation.
However, a better argument is if the insider trader bought a ton of “put” options at high price from a market maker. The people holding the other end of the options would be screwed and clearly identifiable. I think it would make more sense to punish people who do those trades than public stock trading.
Also, it’s worth noting that there is a similar situation for “lemons”, referring to cars with manufacturing defects. This is an information asymmetry problem regardless of whether selling them is immoral. Even if you’re a nice person and tell everyone who inquires all the problems with your car, they may think you are still hiding something, since everyone has to assume any car may be a lemon. Thus, we need other ways around this market failure. Government is one method, but it’s got its own issues, as it’s not very agile, subject to political graft, etc. A better one is cheap inspections offered by local mechanics, which help fix the problem. Another is companies like CarMax, which have a national corporate reputation that would be damaged if they sold lemons.
The point being that long-run, as I mentioned before, allowing insider trading might actually be beneficial, as information leaks more freely when there are clear incentives to leak it. Going back to the put option example, the holder of the option knows they are exposed, so they are incentivized to sell some underlying stock as soon as they make the deal with the (unknown to them) insider. It’s one level removed from the insider directly trading on the stock price, but there’s still an incentive to reflect the insider knowledge in the stock price. Moreover, options can be traded as well as stocks, so a put option seller could be selling to both insider and non-insiders at any time; that again creates the situation that the “victim” would have likely had very similar things happening to them regardless of the insider trading (assuming a pretty liquid market). Again, the seller of the options is actually better off in the hypothetical world where there is an insider trader if you assume they would be selling these options regardless. The insider drives the price of the options up the more he buys them.
Information is valuable, and I don’t think it’s practical to expect everyone to have perfect information all the time (this is a consequentialist argument). If someone sells you their old crappy car, it doesn’t feel like he’s an outstanding person, but on the other hand, when someone lists something for too cheap on craigslist, it doesn’t seem like buyers should be required to tell them the item has been undervalued. Maybe they know that, but are moving this week, maybe they have two of something and the second one just isn’t worth the effort to talk to lots of buyers. And shouldn’t anyone selling know not to take the first offer?
In some sense, every agent in a trade has access to information the other person doesn’t have; this is the source of consumer surplus. You can buy cold medicine for cheap at a local pharmacy because the pharmacy has no way to price discriminate between rich people who are feeling terrible with a cold and would pay $200 for Sudafed, and someone who is cheap and only buying it just in case for $10. This results in huge consumer surpluses on almost every good, yet no one would seriously argue pharmacies or grocery stores are getting ripped off because they can’t tell how much you’d be willing to pay for every item. Some renters may be ready to do all sorts of bad things to an apartment, while some will leave it in perfect condition. Is this unfair that the landlord doesn’t know what kind of renter their tenant will be? I don’t think so. So then what makes insider trading economically special?
The real question is whether the decriminalization of insider trading creates perverse incentives to waste resources on finding out information. We already spend way too many societal resources on stock trading in my opinion. Reducing the clearing of stock market trades to once a second or once a minute would have minimal impact on long-term knowledge gathering about company performance, yet it would stop incentivizing millions of dollars spent on fractional-second computerized trading. Insider trading means firms could get a new edge by hiring infiltrators and detectives to get information on a company, or even just their financial data. Even though I believe strongly that the information usage of insider trading to make money on the market does not create victims and thus isn’t worth prosecuting, there is a risk that actual actions that insider trading incentivizes are negative.
Companies are free to run their organizations as desired, but as Matt Yglesias points out, right now they outsource enforcement of insider leaking to federal authorities. It might prove cheaper to have the Feds enforce information security than to have each company do so. CEOs might also be incentivized to trade on their knowledge, paying off others, securing information and funneling money through intermediaries, which is all wasteful. Of course, companies would want to avoid this, and so they might come up with good systems to thwart any approaches. However, interests external to the firm, like investment bankers or private equity, would have incentives to buy insider information from detective agencies, leading to an industry that wastes time tracking down these now legal information leakages.
Matt Yglesias notes this would lead to elements of a low-trust environment. I think there is some truth to that, but I think it’s also clear that jail time for insider trading is not a good use of societal resources. I think high fines and attaching names to guilty verdicts should be effective enough. Sending people to jail doesn’t protect anyone since there are no victims. Disincentivizing behavior monetarily and through public shaming should be enough, and I think it’s worth trying. Of course, this isn’t a a vital immediate criminal justice reform needed, but rather should be done as part of a larger rethinking of the criminal justice system as a whole.
All trading by insiders is insider trading. Public reporting of company conditions is never complete.
But compensating insiders with stock and options creates a useful coincidence of interest.
So how do we resolve the dilemma? It’s rather simple: require that insiders post their trades at least a month in advance. These posts can include stop losses (also publicized), and a bit of anonymizing so the public doesn’t no which insiders are offering the trades.
Now, the public can use the information before the fact. Smaller corporations can benefit if we allow them to abide by this rule vs. giving public shareholders the right to sue if there is missing CYA verbiage in an annual report.
Yes, this means insiders trade at a disadvantage. Kind of offsets the advantage of being an insider.
By the way, the rule I mentioned in my previous post could be voluntary, a contractual clause that is part of a corporate charter. Such a clause would make the stock more valuable to the general public.