Insider trading IS harmful, but legalise it anyway

The usual argument in favour of legalising insider trading is that it is not actually harmful (or even beneficial) to investors. I think that insider trading is extremely harmful and in-ethical, but it should be legalised anyway. My reasons are the difficulties in enforcing the law, and the probable effects on markets of legalisation.

I am not a believer in strong form market efficiency. Neither am I a free market fundamentalist who believes nothing should be regulated. Insider trading allows insiders to profit at the expense of other investors, destroys faith in markets, and is fundamentally unfair.

Insider trading laws have been failure. While there is occasionally a successful high profile prosecution in the US, they are rare. I cannot even remember the last big case before Rajaratnam. Successful prosecutions are even rarer in the rest of the world, and very few big fish have ever been convicted in the UK.

Insider trading remains pervasive. Every study shows consistent patterns of price movements prior to news releases: proving that insider trading happens. The fact of further price movements after news is released disproves strong form efficiency: the price clearly did not reflect the undisclosed information until it was disclosed.

At the moment insider trading is not supposed to happen, but it does. The pretence that it does not gives investors false confidence. It is better to have no faith, than false faith, so I say destroy investors faith in the markets: it is better to tell the truth. The law is hard to enforce (because of the paucity of evidence) even when it is broken, and the difficulty

What would the consequences be? I must admit that in the past my opinion was that they would be disastrous: markets would seize up leaving most investors with very few options for saving. Companies would not be able to raise money for expansion from the markets. The economy would be owned by plutocrats due to the inability of small companies to expand, and the inability of the public to invest though the markets with confidence.

I changed my mind because a range of other possibilities occurred to me. Looking at possible scenarios, the end result is likely to be better than the sham we now have.

The worst case scenario is that investors will discount valuations for the risk that there is price sensitive information that has not been disclosed. This happens in poorly regulated emerging markets. In those countries lack of faith in markets due to insider trading does often inhibit the development of capital markets, and does hold back economies through all the consequences I used to fear. In a developed market where shares (and other securities) are widely held, and most money is managed by investment professionals, I think the different path will be followed.

The most likely to withdraw completely are are individual investors. What I expect is that fund managers will take great care they have to ensure that they do have all the information before investing: financial markets will work rather more like private equity does, with extensive due diligence. Individual investors will invest through fund managers, as that would be the best alternative left to small investors who ruled out running their own investments. This would make markets a lot less liquid, but far from ineffective at fulfilling their primary purposes in the economy, of allowing companies to raise capital, and individuals to get better returns.

The best case scenario is that markets would be forced to respond by raising standards. The better a company was at disclosing publicly what insiders know anyway, the less its securities would be discounted for the risk. This would create an incentive for transparency. Once a reputation for honesty with investors becomes important it would create a culture that values honesty, whereas tight regulation tends to create a culture that rewards the ability to push restrictions and find loopholes.

There are precedents for a culture of integrity and enlightened self interest making financial institutions work without the threat of punishments. Trading on the London Stock Exchange once relied on floor brokers keeping their word, which is why it adopted the motto “dictum meum pactum” (my word is my bond). The great mistake of modern law and regulation (and incentive schemes), and not just in financial markets, is to rely purely to selfish incentives, and ignore the far greater importance of prevalent values and attitudes.

Once obvious response to all this, is to suggest that the law be enforced more vigorously, or strengthened and enforced more rigorously. I do not believe that this possible. It is difficult to define inside information, and there are too many sources of extra information that lie outside the definition (information from sales channels, information that is not directly price sensitive, etc.) but can be significant: especially in aggregate, or because of inferences that can be made from it. It is too hard to prove what people knew and when and why they made decisions. If a CEO said that a lunch with a big investor was purely private and all they discussed were their kids and hobbies, how to you prove otherwise?

There is also a real lack of will in committing resources to going after lots of rich and influential people (the more money people have or control, the more damage their insider dealing does) committing a non-violent crime with very little likelihood of leaving enough evidence to be convicted.

The most practical solution is to give up on prohibition, and hope something better will evolve.

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