The FSA is promising to crack down on insider dealing. No-one in the City feels the need to change his underpants. After all, what chance do public sector workers have of ever recognizing a well-informed decision?
Which raises the question. Why should insider trading be illegal at all? How can knowing what you’re doing be a criminal offence? Some good judges think it shouldn’t be.
There are (at least) three arguments for legalizing it:
1. Insider trading would improve market efficiency, by ensuring prices reflect all available information.
2. It would reduce market volatility, by reducing the power of noise traders. Today, people who rightly fear a share is under-priced (or over-priced) are reluctant to buy (or sell) for fear that mug punters will drive its price further away from fundamentals. If the numbers of informed traders rise, this problem will diminish. And lower volatility should mean higher prices generally.
3. The only victims of insider trading are ones who choose to be. No-one forces someone to sell a share at £10 if it is worth £15, or to hold a share at £15 if it‘s worth only £10.
So, why should insider trading be a crime? One of the stronger arguments is something like this:
Imagine an oil company’s geologist knows he is about to discover a big oil deposit. Before announcing his finding, he and his friends buy the company’s stock at a low price. The gains from his discovery therefore accrue to him, rather than to shareholders. If shareholders fear this will happen, they’ll under-invest in oil companies, with the result that we’ll get too little investment in resource discovery. Efficiency requires that the property right in oil discoveries lie with shareholders, not employees.
But this argument doesn’t justify a law against insider trading. It merely justifies a clause in our geologist’s contract forbidding such behaviour. And such a ban might not be desirable; allowing a little insider trading might be a good way of incentivizing the geologist to find deposits. This is an issue which shareholders and the company should decide. It‘s not to be decided by general laws against insider trading.
So, why are there such laws? I suspect they owe more to the power of vested interests than to economic logic. If insider dealing were legal, brokers and financial advisors and other charlatans who offer share tips would lose their credibility. A ban on insider trading protects these quacks.
More: here’s an overview of the issues.