Why is insider trading illegal?

Insider trading can hurt investors - and that is the reason why it is illegal, not because its unfair.

bIastoiseIt doesn't seem to harm anyone; yes it gives an unfair advantage to those in the know but since the market isn't zero sum it's not like the avg investor is getting screwed by a connected hedge fund manager. Unfairness that doesn't hurt anyone should not be illegal imho

Or am I missing an important point here that is the true reason for banning insider trades?

Good points. Also, don't forget that insider trading would lead to more efficient capital markets and more accurate prices, which is (obviously) a good thing. I actually don't see the justification for these regulations. But, then again, I feel that way about most regulations...

Here's a short article on the topic: http://www.econlib.org/library/Enc1/InsiderTrading.html

Far from the clearly settled moral issue that naïve media pieces, movies, and novels would have it be, both the theory and the evidence of insider trading remain primitive and equivocal. Present rhetoric—and law—have far outrun present understanding.

The basic argument against insider trading is that insiders should not be permitted to earn such sums at the expense of uninformed traders. Yet in almost all other markets where information is important, insider trading is well established and widely accepted. For example, mineral leases are routinely bought by those better able than the sellers to evaluate a site's potential, as Texas Gulf Sulphur's behavior exemplified. Cattle buyers rely on superior estimates of what packers will pay when negotiating with ranchers. And so it goes, in markets for art, for real estate, for professional athletes—indeed in practically every market with substantial variations in prices. In all those markets a few buyers routinely profit from knowledge that most sellers do not possess, and a few sellers profit from knowledge that most buyers do not possess. Commentators rarely cast aspersions on such traders' ethics or contend that their transactions should be regulated because of the asymmetry in information. Why should securities markets be treated differently?

One reason frequently cited by policymakers and commentators is that insider trading undermines public confidence in the securities markets. If people fear that insiders will regularly profit at their expense, they will not be nearly as willing to invest. A similar argument is that companies prefer that their securities trade in "thick" markets—that is, markets with many traders, substantial capital available, and frequent opportunities to trade at readily observable prices. Efficient securities markets, it is argued, require a "level informational playing field" to avoid frightening away speculators, who contribute to securities market liquidity, and investors, who could invest their savings in markets with less risk of insider predation. Working on such a premise, over the last quarter-century the SEC has brought new and ever more stringent enforcement initiatives against insider trading.

Related to this argument is the harm that insider trading causes for "specialists." A specialist is someone whom the stock exchange appoints to ensure that a buyer of a particular security listed by the exchange can readily find a seller, and vice versa. These specialists must buy from or sell to any trader whose order cannot be offset against other orders arriving simultaneously. If, for example, a buyer wants a hundred shares of IBM, but no one wants to sell at that moment, the IBM specialist sells from his inventory of IBM stock. The specialist charges a "bid-ask spread" to cover the cost. A bid-ask spread implies that a slightly higher price is asked from someone who wishes to purchase a security than will be contemporaneously offered to someone who wishes to sell.

An inside trader, however, will sell securities to the specialist when only he knows that the securities will soon be worth less. After the price has fallen, the insider is free to repurchase the securities from the specialist for the lower price. If that occurs, the specialist loses money. If insider trading recurs, the security's specialist cannot continue indefinitely without recouping the funds being lost to informed traders. Therefore, specialists will insist on larger bid-ask spreads if insider trading is permitted and occurs often.

To investors, the bid-ask spread is a trading cost. If insider trading increased the spread but did nothing else, it would decrease a security's attractiveness relative to certificates of deposit, government bonds, and other assets. Raising new capital would, thus, be more costly for a firm whose securities were subjected to repeated insider trading. Hence, all else being equal, insider trading makes it harder for a firm to raise money when opportunities to undertake new projects arise.

But insider trading might also have offsetting benefits. Insider trading can be profitable only if securities prices move. Therefore, insiders hoping to trade on inside information may try to get the price to move by cutting the company's costs, seeking new products, and so on. While such actions benefit the insider, they also benefit the firm's security holders as a group.

Of course, insiders can also profit by borrowing and then selling securities when the price is apt to fall. Some argue that insider trading is more likely to harm companies because damage is easier to inflict. That argument, in turn, has been countered; major actions by a company require teams, not individuals. Efforts to damage a firm would likely be brought to the attention of higher management or shareholders by some ambitious team member looking to capitalize on the resulting gratitude. Unfortunately, no evidence has been presented to help resolve this debate.

A number of financial economists and law professors take the position that insider trading ought to be legal. They base their case on the proposition that insider trading makes the stock market more efficient. Presumably, the inside information will come out at some point. Otherwise, the insider would have no incentive to trade on the information. If insider trading was legal, this group argues, insiders would bid the prices of stocks up or down in advance of the information being released. The result is that the price would more fully reflect all information—both public and confidential—about a company at any given time.

Even if insider trading sometimes creates more harm than good, rules against it could be contractual (e.g., "employees of our company who trade on material, nonpublic information forfeit their pension rights") rather than mandated by government. Because the circumstances facing companies differ, insider trading might be advantageous for some companies and not for others. And if so, would it not be sensible to permit firms to "opt out" of insider trading enforcement? Interestingly, Texas Gulf insider Charles Fogarty was subsequently elevated to chief executive officer of his company. Moreover, following Fogarty's death, another insider, who was also known to have traded on the same information, was elevated to replace him. Clearly, Texas Gulf's board of directors and shareholders must not have found the trading completely reprehensible. Yet the law makes no provision for opting out, implicitly assuming that insider trading injures all companies. Policymakers never seriously ask who is harmed, who is helped (other than the insiders), and by how much.

Is this question a joke? Insider trading takes capital from productive investors and redistributes it to frauds. It harms the integrity and functioning of the market, harms the investors on the other side of the trade, and destroys value/capital through inefficient allocation.

The idea that no one is harmed is totally sociopathic. When someone trades on inside information or uses other manipulative practices it means my state's pension fund doesn't perform like it should and I'm stuck with higher taxes. We give banks/bankers enough legal ways to reallocate capital to themselves without actually doing anything productive. The suggestion that we should just allow outright theft is disgusting.

rampant insider trading would cause the general public to lose faith in the capital markets. i live in a country where the stock market is dominated by large entities trading on insider info and you constantly see unexplained large changes in stock prices. i would never put a dime in there. fundamentals dont count for shit. Im much more comfortable trading the US or european markets... at least there is "some" sense in what is driving prices.

because it is important to sustain the public illusion that they are trading with the pros on a fair basis.

Econ, i would think that someone who is so adamantly against excessive taxation (theft) because it is essentially unfair and limits our personal freedoms would be able to see the similarities between insider traders and thieves. My purchase of public securities for a LBO target that my shop is pursuing, knowing full well when the final bid deadline and announcement deadline will be, is the same thing as me being a bank employee with knowledge of the vault code and stealing the contents of the safe.

Largely a victimless crime.

I actually wrote my MSc thesis on the ethics of insider trading. Got an OK grade as well. This was spurred on by a European Commission survey on whether insider trading regulations should be extended to commodities, and my observation that every organisation that replied seemed to have either no clue or have a direct stake in the outcome.

Basically, there's two avenues of thought - 'rights' ethics (the word is "deontological"), and 'utilitarian' ethics. Insider trading could be found unethical according to either of these.

Rights ethics deals with what is right and wrong in itself, like the situation has some kind of moral value. An example of a rights-based argument would be "insider traders misuse information that belong to the company, and this is immoral". An example of a utilitarian argument would be "insider trading reduces faith in the markets, economic growth and human happiness and this is bad". There's a million arguments that can be classified under either category.

If you really hate insider trading though, well, in several places in the world it's legal and for large parts of history it was, but the world didn't collapse then either.

Let me know if anyone is obsessively interested enough to want it.

Although I think the OP has a strong point I had a similar inquiry explained to me this way...

A legalization or deregulation of insider trading would likely spawn a rise in the element of collusion. A point at which regulations more stringent than the current insider trading laws were likely to follow in order to eliminate a subsequent risk of failing consumer sentiment.(i.e., harsher punishments for violators and more shades of gray in an already charcoal arena) By eliminating the eligibility of those with information not privy to the average consumer, the market is considered to be more efficient.

I took this to mean that in the process of trying to create a level playing field for ALL investors there are some market inefficiencies, and the current SEC regulations against insider trading are the least detrimental by comparison to long term worst case scenarios.

I disagree with insider trading being equated to a vault combination.

I personally feel it would create a more efficient machine and agree with points identified by SpiderMonkey. Over time, it would likely result in the creation of a premium paid for direct to market information (fraught with lemmings and posers, another element which complicates matters for consumers) in addition to the existing trading markets. In all reality, the average consumer is at just as great a disadvantage with current insider regulations as it would be without. They would just know it instead of being fooled into believing in a fantasy world of perfect information.

Hi guys - all these arguments are well-reasoned and eloquently put. Please keep this kind of civil and intelligent discussion out of WSO, it is clogging up the servers. Please stick to debating which group has the best exit opps and what exactly constitutes a non-target/semi-target/target school.

Thanks.

The one rather interesting proposal I remember was to make price-decreasing (shorting or selling) insider trading information legal. Basically the argument is that there's a lot of people in the market who benefit from talking up prices but very few who benefit from talking down prices, leading to impaired allocative efficiency. Some ethical issues you still have (the buyer would have less information and be unhappy in retrospect) but many of the managerial issues associated with price-increasing insider trading (like inflating accounting numbers) would not be there. I can agree it's really unlikely to be implemented in any current developed nation, but an interesting thought experiment.

^^ So instead of incentivizing insider managers to perform well, occasionally fudging to the upside, you'd incentivize them to tank the company while holding short positions?

Edit: I didn't mean "you" personally, just whomever might be doing this :). I noticed you didn't actually suggest we go this route. It's an interesting thought.

The one other point I think it's important to remember (not related to above), is that the stock market, excluding dividends, is zero-sum on a cash flow basis. Any realized gains come either through dividends or from other market participants' cash losses. Any gains from insider trading necessarily come 100% at the expense of other market participants. It's simple math. The money doesn't appear out of nowhere.

This is regardless of any structural harm caused by the perception of unfairness.

Troll is successful.

Trades just move cash. No cash is ever created in the process. If an insider increases the cash in his bank account, someone else has lost the same amount.

The market is abstract and anonymous. There's moral hazard in not seeing the victim(s). Reality though is not complex at all. If you make money on a trade, someone else loses money. Period.

...and yeah, we got trolled, but this made front page and it's a slow day :-/.

If you allowed insider shorting there would absolutely be an incentive for someone to sabotage the firm they work at. This would however a) generally work against their own interest in terms of salary, b) lead to their dismissal and blackballing for the rest of their life, c) make them subject to claims for damages, and if there's any suspicion the motive would be easy to establish.

At the same time you should be able to avoid more corporate fraud. Take Enron for example. What if everyone who didn't get stock options had been allowed to short the stock from day 1? You would have seen some people take big shorts and then a lot of leaks to the market, at an early stage, before it became as big as it did. Arguably if there is a problem at a firm, then any period of time this problem isn't known to the market is a period the stock is mispriced. Remember that positive news tend to be published right away, but everyone involved has an incentive to keep negative news secret. You would even say that stockholders and managers (one supposed to be 'checking up on' the other) both have an incentive to overstate positive news and hide negative, so managers would never be "punished" for doing that by anyone.

The overall effect should be that there would be a lot more negative rumours floating around in the market about every company. This would bring prices down, one-off, and when companies develop problems they would be reflected in the market a lot sooner, to the betterment of price accuracy. Arguably however the situation today is that companies are impenetrable fortresses of Everything Great and it's only if the shit REALLY hits the fan that problems get aired out, and then you get everything at once. If people had an incentive to short then the flow of information regarding companies would be a lot more nuanced.

The argument isn't mine and was made by someone else many years ago, but it's an interesting thought.

Insider trading shouldn't be legalized because I want trading to stay as a meritocracy.

That's a pretty simplistic view, Ragnar. Where does research end and insider trading begin? Just because I've gone to the effort to get to know a CEO (for example) and know his company inside out and backwards and am therefore privy to information the investing public has neither the willingess nor ability to attain, that makes me immoral?

Because lawmakers are a bunch of money-hating commies, DUH.

In terms of profiting from realized gains, equity markets are indeed a zero-sum game.

BECAUSE MAKING MONEY SHOULD NEVER BE THAT EASY!!!

Think about it, insider trading is legal, suddenly no wants to make an honest living they just want to exploit knowledge to make money out of thin air.

people who do insider trading should be jailed for life

...

as

When was it ever illegal? Pretty sure the Chinese wall is just a fable for illustration.