Why Is Insider Trading Even Illegal?

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Ever since the financial crisis, U.S. regulators have been hard at work putting away Wall Street financiers who play fast and loose with the law. The only problem is, those Wall Street crooks that the feds have been cracking down on aren’t those who actually caused the financial crisis, but a different breed of white collar criminal: inside traders.

As Charles Gasparino explains in his new book on insider trading, it’s largely coincidental that the fed’s recent crackdown on the practice — which includes yesterday’s indictment of the hedge fund SAC Capital – is taking place in the wake of the worst economic recession in several generations. But the coincidence does provide opportunity to ponder why — given the fact that insider trading isn’t anywhere near as pernicious a crime as some other white collar shenanigans — the government spends so much time and energy trying to stop it.

(MORE: Steve Cohen’s (Allegedly) Corrupt “Information Gathering Machine”)

In fact, there are large number of professional economists and legal theorists — albeit generally of the libertarian persuasion — who feel that insider trading shouldn’t be illegal at all. Doug Bandow, a senior fellow at the Cato Institute, for example, writes:

The objective of insider trading laws is counter-intuitive: prevent people from using and markets from adjusting to the most accurate and timely information. The rules target “non-public” information, a legal, not economic concept. As a result, we are supposed to make today’s trades based on yesterday’s information.

Unfortunately, keeping people ignorant is economic folly. We make more bad decisions, and markets take longer to adjust.

He goes on to argue that the goal of insider trading laws, which is to promote a fair stock market, is misguided. Every day stock market participants trade securities based on incomplete information. In nearly every transaction, one party has superior information than the other. Furthermore, it’s only possible to enforce insider trading laws when a trader decides to buy or sell a security. But the decision to not trade a security is sometimes equally important. If your inside source at a company whose stock you don’t own gives you a peak at a financial statement, and it’s disappointing, you will decide not to buy that security. And that decision is illegal, but can never be proven. Writes Bandow, “You’re entitled to rely on the best and most timely information so long as you do nothing. Such a rule is not likely to improve private investment decision-making or promote more efficient markets.”

Finally, Bandow argues that insider trading laws prevent the market from reflecting all available information about securities. By preventing those who know more about a stock from acting on that information, you impede the natural tendency of markets to set a fair price.

These arguments are not new. Ever since 1934, when insider trading became illegal in the United States, theorists have argued about the merits of such restrictions. But what may come as a surprise to many is that even though insider trading has technically been illegal since the 1930’s, regulators have only been enforcing the law with vigor for the past 30 years.  That changed radically in the 1980s, when several new laws were passed to stiffen penalties for insider trading, and regulators started bringing many more cases against Wall Street.

So why was there a sudden shift against insider trading in the 1980s, and what is the rationale behind these laws? While it’s true that, as Bandow argues, insider trading deprives markets of some pertinent information, allowing insider trading would weaken other pillars of a modern securities market.

(MOREBusting Steve Cohen: How a Minor Charge Threatens a Major Figure)

One such organ of modern financial system are market professionals like hedge fund, pension, and mutual fund managers. These are the people who spend significant time and resources digging up non-inside information about the economy and individual firms. For instance, big hedge funds often produce vast amounts of research concerning companies using publicly available data from the government or private institutions. This information helps make markets more efficient and helps to price assets more accurately. But if insider trading were legal, it’s possible that all this work may not be worth it when competing with insiders and those able to get hold of insider information. If these market professionals leave the market as a result, it could lead to much less efficient markets.

Second, insider trading most certainly puts the average investor at a disadvantage. If the nonprofessional investor feels that he can’t participate in the markets without getting ripped off, he’ll also leave the markets. Just as with professional money managers, this will have the effect of reducing liquidity. Reduced liquidity in turn means that those who do invest will pay less for a stock because of the risk that they won’t be able to sell it when they want to — and this in turn makes the cost of capital for firms more expensive and the economy less efficient overall.

Another effect of decreased liquidity is on so-called market makers: the folks who hold a large inventory of a particular security and will buy that security slightly cheaper than it will sell it. That price difference is called the “spread,” and it represents the market maker’s profits. Fewer participants in the market mean wider spreads, as market makers have to make up for decreased volume. Bigger spreads mean less efficient markets — as less capital is getting to those who will most efficiently make use of it.

The conclusion that researchers from the Federal Reserve Bank of Atlanta came to when looking at all these effects is that insider trading laws do indeed present a trade off. On one hand, insider trading laws distort the market by making it more difficult for prices to reflect all available information. On the other hand, a developed and modern securities market relies on the participation of different types of investors with different motivations and levels of expertise — and without insider trading laws many of these types of investors would stop participating.

(MOREInsider Trading: Bad, But Not the Real Scourge of Wall Street)

And this explains why it takes so long for nations to develop insider trading laws. (Insider trading rules were laughably lenient in the U.K. until 1980, for example.) When an economy is young, it often doesn’t have a developed financial services sector with people whose dedicated job is to make markets or trade for a living. Markets in such economies have few sources for information about the economy and the individual companies, and so it is important for inside information to be able to filter its way through to markets. But once an economy is mature, it can forgoe these sources of information in the name of more robust markets.

Ultimately, however, Congress didn’t establish insider trading laws because of such refined economic theories. For better or worse, Congress doesn’t set policy by soberly analyzing economic models. Often its actions simply reflect the emotional will of the American people. And Americans like fair play. With this in mind, it’s easy to see why insider trading rules contain some of the contradictions Bandow emphasizes, and why we often see them most strictly enforced during times of financial excess — even when that excess isn’t a result of insider trading.

11 comments
commanderotto
commanderotto

I smell new journalist here....


Insider trading laws are there to keep the markets stable. It exists so that everyone is buying stocks and bonds on the same level. It exists so that companies acquiring other companies don't get ripped off either. You obviously did not study economics man.

drudown
drudown

Perhaps a more pertinent inquiry is "how is not illegal for elected officials in Congress to allow market players/campaign contributors to 'ghost write' Legislation on behalf of the People which emasculates the consumer protections contained within, inter alia, the Dodd-Frank Act?"

I forgot.

The Media and modern Academia is on the take just like Congress.

soup831
soup831

Marxist equality, ie, the destruction of the most productive people, is the context of insider trading laws. They are not based in the science of production for a market. I dont mean that all advocates are Marxists. Most are concrete-bound Pragmatist fools.

dblevene
dblevene

This article is quite good but gets a few minor points wrong.  It is not true that "insider trading has technically been illegal since the 1930′s."  The SEC's Rule 10b-5 as originally enacted said (and to this day says) nothing at all about insider trading.  At the time it was enacted, no one - not the SEC, not any law professors, not any trader - thought that it prohibited insider trading.  All Rule 10b-5 prohibits is fraud in connection with purchases or sales of publicly listed stock, i.e., intentional misrepresentations, including telling half-truths.  It says nothing at all about maintaining silence while trading.  The judicial stretching of the prohibition on fraud to include trading while in possession of secret information did not happen until the 1960s, when the SEC took the position that Rule 10b-5 should be "interpreted" by the courts to include a prohibition on insider trading.  Since then, the SEC has obdurately refused to issue a definition of insider trading and has opposed any efforts by Congress to enact one.  


The author might also have mentioned that no one is hurt by insider trading.  Whoever sells to or buys from an inside trader was going to make that trade anyway, whether or not the inside trader traded, so the insider trader's purchase or sale cannot in any sense be said to have caused whatever loss the counter-party may have suffered.  

There is a vast economic and legal literature on insider trading and to this day there is no consensus among economists and law professors about its effects.  IMHO, the only plausible argument for making insider trading illegal is the claim that such a prohibition is necessary to encourage investors to trade in the stock markets.  However, there is very little economic evidence supporting this claim and there is substantial evidence that the prohibition on insider trading makes markets less efficient.  Nonetheless, the public doesn't like it and the politicians and prosecutors have found that prosecuting insider traders is the way to fame and higher office, even if the time spend chasing after inside traders would be better spent going after real fraud, like Bernie Madoff.  



soulwayfarer
soulwayfarer

Time Magazine was probably more ingenious than ingenuous in taking on this token conservative. What better way to discredit the right by having it represented by nitwits.

jp_pete
jp_pete

This is an incredibly stupid article about an incredibly stupid idea. Bandow is quoted as saying, "The objective of insider trading laws is counter-intuitive: prevent people from using and markets from adjusting to the most accurate and timely information." 

However, the reality is that the goal of insider trading laws is the exact opposite. Insider trading laws are about allowing markets to adjust to the latest, most accurate information before a handful of privileged elites with inside access game the system. 

Furthermore, the object of insider trading is to flip stocks for gains based on short-term price fluctuations, but it's precisely this "stocks as gambling chips" mindset that leads to the risky and reckless financial practices that inevitably cause economic recessions and depressions. 

As counterintuitive as it might seem for a journalist to do actual research, perhaps Mr. Christopher Mathews should do some research into the causes of the Great Depression. This is shoddy journalism, and there isn't a single incontrovertible fact in the entire article. It's a collection of extreme-libertian theory. What a disgrace that Time publishes trash like this. 

commanderotto
commanderotto

I mean nothing against you... you made a nice try in explaining both sides, but I feel that you still need to understand the concept of why insider trading is not allowed. It is a very complicated thing to understand, so I don't think you are a bad journalist because of this. I really recommend you watch the movie "Wall Street" (from the 1980's), with actors Charlie Sheen and Michael Douglas. Only after watching that movie will you understand why it is illegal.

bourgeoisboy
bourgeoisboy

@soup831 It is not constructive to liken insider trading laws to Communism. Name calling only polarizes the conversation and breeds animosity. 

drudown
drudown

@dblevene 

Taken to its illogical conclusion, you conspicuously omit any reference to the scienter to violate federal law. One can think a wide array of laws which- if consciously violated- may likewise be self-servingly construed as "not hurting anyone." How is that a working hypothesis when juxtaposed against regulatory infractions and specific-intent crimes? Do tell.

LanceSjogren
LanceSjogren

@jp_pete 


Surprising too that Time publishes this.  Usually they just publish stuff by leftist crackpots.

soup831
soup831

@bourgeoisboy @soup831 Insider trading laws enforce equality of knowledge, an obvious application of egalitarianism and an obvious contradiction of human nature. But, to mystics,  nature is judged by an ideal instead of the reverse.  


Polarizing identifies principles (name calling). Man needs principles to organize his mind's knowledge of concrete reality so that he is not lost in a worthless, short-range, Pragmatist chaos of information. Mind is man's basic method of survival  in nature and society. Mind should never be sacrificed to society. Only rational society furthers man's survival. Irrational society is destructive to man's life. Sometimes animosity is a need of man's surivival. Man needs production and trade to further his life. These require knowledge of reality, the more knowledge, the better. Insider trading is guided by the best knowledge of the best investments for always limited resources. This benefits all.