Legalize insider trading

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.

Comments

[Alexander Campbell]

How about this:

Insider trading is illegal because company officers have a moral duty to report promptly all material information to their ultimate employers, the shareholders (effectively, to the market as a whole). Insider trading, by definition, means that they have failed in this duty; the insider information must be material, because otherwise the insiders wouldn't be trading on it, and they can't have reported it to the market, because otherwise it wouldn't be insider information!

But since it's clearly impractical for all material information (every contract signed? Every daily movement in mark-to-market? Every hiring and firing decision?) to be reported immediately to the market, we've come to a compromise; we let company officers have access to material inside information so they can, you know, run the company, in exchange for an agreement not to trade on it.

Insider trading should be illegal because it actually creates an incentive for company officers not to fulfil this duty - in other words, to withhold information. In your oil geologist example, the geologist and his mates have an incentive to delay the report for as long as they can, in order to go long themselves and get the word out to their friends to go long as well. Insider trading's normally small compared to total issued capital, so the mere fact of the increased demand won't move the price enough to incorporate the information that the geologist possesses - the market, in fact, remains inefficient for longer than it would if the report had simply been released straight away.

The reverse is also true - company officers have an incentive to conceal losses until they've unloaded their own holdings. This, again, is hardly conducive to an efficient market.

[Zorro]

I think it's illegal for the same reason as Blackmail. ie we're ruled by fucking cretins.

Banning this is like prohibiting drugs and is about as likely to work.

[DBX]

It's illegal because you don't have much of a functioning market is one person has the information and everyone else does not.

So why not just sweep away the whole mess altogether and require instant disclosure of more or less everything? A more thorough approach to disclosure would mean that insider trading laws have to be used much less often.

[DBX]

Ooops . . . "when one person has the information". Not "is one person . . ."

[Nick Rowe]

Here's a different argument.

Knowing that insider trading is allowed reduces market liquidity.

Suppose I want to sell some shares, simply because I need the cash for some other purpose. When I offer my shares for sale, potential buyers might think I have some inside information that the value of the shares is lower than the current price, so they refuse to buy.

Conversely, suppose I want to buy some shares, simply because I have some spare cash I need to invest somewhere. When I try to buy some shares, potential sellers might think I have some inside information that the value is higher than the current price, so they refuse to sell.

Of course, this "Market for Lemons" problem always makes markets less thick (or liquid) than they otherwise would be, regardless of insider trading laws. The question is whether the costs from the loss of liquidity from allowing insider trading would be greater or smaller than the benefits you cite in your post. The answer is not obvious (to me).

[Paul Murphy]

Thank goodness someone is actually debating this issue.

To come at it from a different angle, can the tangible costs associated with the attempted control of information flows (the market abuse regime) ever be justified by the intangible damage actually caused to market integrity and the like?

The regime clearly does not work. In fact, it operates in the favour of the true, organised insider, who gets a bigger turn for their information because the rest of the market is deprived of information that, in a more natural environment, would come their way.

An old market hand once offered a solution (and only half in jest): abolish boardroom pay and make executives punt for the supper. Effective disclosure of price sensitive news would become instantaneous.

[Unity]

One of the ironies here is that there is often one group of employees that rarely gets mentioned in such discussion despite it having the greatest possible opportunity for pulling off such trades without being noticed...

...the IT department.

20 years ago, when I worked for a multi-national I had as much, if not more access to key financial information than almost any senior officer of the company, simply because I was the guy that ran off all the financial reports, and yet, as a lowly operator, there was never any thought amongst the senior staff that I might be in a position to turn that to my advantage.

It's not just the people at the top who could have an edge, sometimes its the ones at the very bottom as well.

[Rob]

I'm on the fence with this one.

I can see that it could be argued that physical commodities are generally traded with someone having some inside knowledge. For instance, some people trade in rice for instance and don't give a hoot about the situation that the grower is in, and they use their privileged position to ensure that they maximise their profits in the marketplace. Isn't this a case where someone in the supply chain is using their insider knowledge, which they hold close to their chest, to improve their trading position?

It could be argued that stocks and shares should be no different, except that it may affect the people who invest in the organisation and of course the professional traders.

So it seems to me that the question is whether the investors need to be protected. This thorny issue is reluctantly grasped by governments who, in the end, bale out investors where it all goes sour.

Isn't Northern rock such an example?

This leads me to suggest that governments feel the need to protect themselves by trying to ensure that the circumstances under which we, the people, pick up the tab are restricted.

[reason]

Of course the problem is asymmetrical information. When you play poker do you show your opponent your hand and let him keep his hidden?

[reason]

Should goalkeepers be allowed to bet on games they play in?

[oops]

when the guys from citibank were hauled up in front of congress they said that their compensation plan required them to hold onto their stock as long as they were employed tthere. they couldn't sell much.

that did wonders for transparency and information flow to the markets.

might be better to allow the sales and allow the public to track the sales.

countrywide's ceo sells a lot of stock and the price dives. citi's price dives and no one was allowed to sell. what does this tell us?

[jameshigham]

Which raises the question. Why should insider trading be illegal at all?

Thought Unity's comment interesting here.

[Simon Stephenson]

Perhaps you would excuse my naivety, but could someone tell me what differentiates insider trading from common or garden theft?

After all, the geologist is employed, ultimately, by the shareholders of the oil company, and is paid a salary in return for acting in their interests. I don't see how this could be taken to include appropriating the capital gain of one or more of the shareholders during the period between discovery and announcement?

There are, of course, alternative arrangements that would allow the geologist, quite reasonably, to assume the lion's share of profit from his discoveries - but I don't really think that he should expect these arrangements to include having all the exploration costs paid for by (the shareholders of) the oil company, discovery or no discovery. Nor, indeed, to be paid a salary by the said oil company, on the same basis.

[ad]

"Insider trading is illegal because company officers have a moral duty to report promptly all material information to their ultimate employers, the shareholders"

Alexander, surely the shareholders could put such a requirement into the employment contract, if it is of benefit to them? So there is no need for a law.

And if it does NOT benefit the shareholders, I do not see how it could be a duty to them.

[dsquared]

Lots of unsupported quantitative assertions here:

[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.]

Absolutely not. You see a share dropping in a market where insider dealing is legal - who on earth would have the nerve to buy? Under your regime, people who rightly believe that a share is under or overpriced would be far more reluctant to trade on it, because they would be worried (incorrectly) that its current valuation reflected non-public information.

[If insider dealing were legal, brokers and financial advisors and other charlatans who offer share tips would lose their credibility]

Hahahahaha, surely you can't be serious. Insider dealing was legal in the USA before 1930 and this wasn't how it went down. If insider dealing were legal, brokers and financial advisers would spend every minute of every day passing on "inside" tips.

[Guillaume]

RE:
[Should goalkeepers be allowed to bet on games they play in?]

Sure, if I know they can do it AND I know when they do it.

If I know that someone is trading AND I know the person who is trading is an insider I can assume she holds relevant information and act on that basis.

From this PoW, Insider Trading could be allowed and improve information flows and transparency insofar that the markets is aware that those people who are currently trading are also ones who (may) hold relevant information. Which is basically what oops said :

[might be better to allow the sales and allow the public to track the sales.]

Though I guess this approach could be hindered by privacy issues. What about a clause in employees' contracts requiring them to make their stock purchases & sells information available for the stockholders to see ? Could that work ?