Nothing wrong with insider trading
Published by Yazad Jal February 1st, 2005 in EconomicsBryan Caplan on EconLog, picks up an old interview from Capitalism Magazine on Legalizing Insider Trading. I agree, but it’s déjà vu (twice in once day!)
Seven odd years back, Ajay Shah convinced me against a ban on insider trading. Here’s what Ajay (then a professor at IGIDR) wrote in the Business Standard (25 March 1998, archived on Ajay’s website).
In order to make sense of insider trading, we must go back to a basic understanding of markets, prices and the role of markets in the economy. The ideal securities market is one which does a good job of allocating capital in the economy. This function is enabled by “market efficiency”, the situation where the market price of each security accurately reflects the risk and return in its future. The primary function of regulation and policy is to foster market efficiency, hence we must evaluate the impact of insider trading upon market efficiency.It is not hard to see that when company insiders trade on the secondary market, they speed up the flow of information and forecasts into prices. Company insiders are in a unique position to make forecasts about the future risk and return of the shares and bonds of their company, hence they might often correctly perceive market prices to be “too low” or “too high”. When they trade on the secondary market, they serve to feed their knowledge into prices, thus making markets more efficient.
Insider trading is often equated with market manipulation, yet the two phenomena are completely different. Manipulation is intrinsically about making market prices move away from their fair values; manipulators reduce market efficiency. Insider trading brings prices closer to their fair values; insiders enhance market efficiency.
If you have no idea what’s being talked about, hail Wikipedia!
Ajay Shah’s argument is incorrect.
While it is accurate to say that the insider allows a swifter reflection of breaking information in stock prices, he/she extracts a significant rent for this service. This rent discourages otherwise savvy investors who aren’t insiders from participating in the market, which in turn, reduces market liquidity, hence efficiency.
We do need more channels for faster, broader dissemination of breaking news — insider trading, while superficially capable of this, in the end hurts the market.
Thus, advocating insider trading is something like terrorists advocating self-determination in Kashmir — their exercise of such a “freedom to choose” will inevitably end up diminishing the very freedom that will make their choice possible. This is a paradox — an apparently liberal act leading to illiberal results.
Which sane person can support this?
umm… Primary Red, I always view comparisons between voluntary market exchange and coercive political actions dubious, though amazingly many people don’t seem to see the distinction quite as clearly.
An argument against “Insider Trading” is essentially an argument for misleading prices in markets. You can read the link to EconLog, which strengthens the point, or, you can make an attempt to understand how markets deal with information. Either way you would reach the conclusion that a ban on Insider Trading is in fact detrimental to the very share holders and market players you claim would be driven away if it is allowed.
Rather than compare it with Kashmir, which really is quite off the point, this is more comparable with asking the MD of Indian Airlines whether or not his planes are air worthy, and having him say that it was illegal for him to divulge that information. It would seriously heighten the risk and uncertainty of flying in the plane wouldn’t it?
I’m afraid, Gautam, this is not as simple as you suggest.
Yes, absent insider information, market prices are misleading — this can be corrected either via insider action (where, structurally, the insider gains at the expense of everyone else less privileged), or via mechanisms for swift, & broad, communication of price-impacting information to the marketplace at large (here gains/losses are distributed solely dependent on a person’s existing position — the impact is random — sometimes he/she wins, other times he/she loses; either way he/she has placed bets about the nature of information yet to be made public, and so fully understands the risks taken).
Who will take risks if they are structurally set up to lose money?
Incidentally, a lot of people who have studied, and participated in, markets a long time (including this writer, professionally) oppose insider trading (it is illegal afterall), and for anyone to suggest that our views reflect a need for us to “understand how markets deal with information” is a bit presumptious.
Re. the Kashmir issue, I was simply pointing out how absurd and counterproductive outcomes sometimes result from seemingly reasonable choices — as will no doubt occur if insider trading is allowed per your prescription.
Regards.
Primary Red,
where, structurally, the insider gains at the expense of everyone else less privileged
The only advantage that the insider has is that he knows a certain trend before the others. A trend which the others will eventually catch on to.
Yes, the insider will gain more, but I dont think it will be at the expense of anybody else.
I do not want to presume that I know more than Primary Red about how markets handle information, but I would presume that at times it helps to stand outside and look throught he window at what happens within, than it does to be part of the proceedings, one might get a different perspective in the least, if not a better one.
Taking that line, I would wonder much like Ajit, how it is that ‘insiders’ benefit ‘at the expense’ of ‘outsiders’. If insider trading is allowed, and people do start trading based on information that is available to them within their company, and is not known to outsiders, and this is known, as you argue who would take a risk at investing in such a company? But that is precisely the point, if insider trading were allowed it could not possibly be misused (once it is an established rule) because it would be a known phenomenon, and people who aim to misuse it would eventually find themselves trading only inside the company.
At the moment the mechanism which prevents insiders from trading, by simpy declaring it illegal does not seem to adequetely ensure that they are not able to make trades at all, it simply makes the cost of getting caught high, and those that feel the gamble is worth it go ahead and gable anyways. Why not have it out in the open.
dear brothers,
primary red, ajit and gautam the topic in consideration is quite intricate and is not as incisive as it appears to be prima facie, a lot of research has been done on the topic and it has been stated on more often than not that insider trading should not be legalized for a lot of reasons
1 insider trading is not a victimless crime yeah, we may not be able to pin point the victim at a point of time
2 an insider is at a better position not by virtue of the hardwork he puts in but just by virtue of being an insider
3 insider trading leads to an unfair game, a scenario where there is no level playing field. it is like playing cards when you know what is the next card in the pile.
dear brothers
this topic has made me think a lot of time though a lot of people state what i have said in different words here, the fact that insider trading increases market efficiency is a major fact that go with legalizing insider trading.
i am a student of finance & investments and as a part of the MBA requirements i am doing a year long project on this topic, it is hard to find people who truly understand and appreciate this phenomenon and since you all are a few of those people, can you help me by sparing 5 minutes of your valuable time.
if you can fill up a questionaire which would hardly take 5 minutes you would be helping me in my project.
if you don’t mind helping me you can mail me at my email id
gmahtolia@gmail.com
i assure you that the information provided by you would be used only for academic purpose and would be kept confidential
i shall remain indebted to you for this kind gesture
govind mahtolia
sri satya sai university