David R. Henderson  

The Problems with Bans on Insider Trading

Piketty on Kuznets... It's Great to Be Back With One...
It is startling to note that at least five-sixths of all insider trading scenarios (it would be practically impossible to measure actual cases) could never be prosecuted, even with a policeman shadowing each and every insider. Why? Consider how inside information can affect the behavior of an insider. He or she can think the stock will appreciate and buy shares or think the stock will decline and sell shares. The insider can also decide not to sell or buy shares. Next, after this action or inaction, the share price can rise, fall, or stay the same. Even if the price rises or falls, it may match the market as a whole, complicating the picture.
This is from Charles L. Hooper, "Insider Trading Turned Inside Out," one of the two Econlib Feature Articles for June.

After this paragraph, Charley goes on to explain how he gets his five-sixths number.

Not that this was planned, because the lead time for such articles is weeks or months, but the article comes at an opportune time. Late last week, the news was about a potential insider trading case involving golfer Phil Mickelson and investor Carl Icahn.

Another highlight:

Consider the case where an insider trades ahead of a public news release. Before the insider buys, investors happily buy and sell at $100 per share. After the insider buys, investors happily buy and sell at the new higher price, say $101. When the news finally becomes public, the lucky ones realize they made $9 per share and the unlucky ones lost $9. The gains and losses were $9 per share instead of $10 without the insider.

The insider did not create the lottery and did not cause anyone to make or lose money. The insider merely took the existing lottery and reduced the magnitude of the losses and gains to the other participants. Those who blame the insider for causing some to lose money ignore two important points: (1) there are those who gain and their gains exactly offset the losses suffered by others; (2) people would have made more or lost more had the insider not acted. In effect, those who blame the insider find fault in the fact that the insider didn't do more to dampen the stock market lottery. To be consistent, they should blame the insider for not shouting the information from rooftops.

Read the whole thing.

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COMMENTS (21 to date)
Phil writes:

After the news is released, the buyers and sellers cancel each other out, as the article says. But the $9 gain by the insider must come from *somewhere*. Where? Perhaps it comes from the seller who wouldn't have sold if the insider hadn't been buying. You can't identify who that is, but does that matter?

Or: perhaps the same number of shares sold, but the insider just happened to outbid another buyer, who decided not to raise his bid from $100. In that case, the buyer who didn't buy is out the $9. (Actually, he's out $10. The insider gains $9, and the seller gains $1.)

If nobody lost, but the insider gained $9, that would be wealth created out of nowhere.

Joe Teicher writes:

The purpose of insider trading bans is to reduce the fraction of informed traders in the market and thereby reduce the spreads that market makers can charge. This article seems to assume no bid/ask spread and therefore finds no harm from insider trading. Perhaps more realistic assumptions would yield a different result?

David R. Henderson writes:

@Joe Teicher,
When you write, "This article seems to assume no bid/ask spread and therefore finds no harm from insider trading,” do you think there’s any contradiction between your claim and this statement in the article: "One legitimate complaint against insider trading is the harm it does to ‘specialists' who charge a 'bid-ask spread' and "make a market" for selected securities."

Joe Teicher writes:

@David Henderson
I don't think there is a contradiction because I just went off the part you quoted and hedged myself with the word "seems."

After I posted I did read the article and I saw the sentence you quoted but was disappointed to see that it was followed by a very weak dismissal. Just because the effect is supposedly hard to see doesn't mean it is not there. Perhaps the people looking did not have an overwhelming incentive to find it. I see situations nearly daily where the vast majority of liquidity will temporarily disappear from a market due to market makers knowing that other participants will soon have an informational advantage. To me that is similar enough to insider trading to make a guess that legalized insider trading could have bad consequences.

Alexandre Padilla writes:

The argument that insider trading increases the bid-ask spread is only an argument that says that market makers lose out of insider trading because somebody knows better about the market than they do. The real questions are (1) does insider trading make markets more efficient or not? Evidence shows that insiders perform above market average, therefore, it means that insider trading makes market more efficient; (2) does insider trading discourage investment and therefore makes more difficult for businesses to raise capital? The answer is no. Most surveys indicate that people believe insider trading is pretty prevalent but that doesn't stop people from investing and buying stocks because they might think they won't be the one suffering from it (maybe they think that the likelihood their trading partner is an insider is very low). Overall, there is little evidence that banning insider trading is efficient in the sense that the benefits of banning insider trading are greater than the costs. Ultimately, a Coasean approach would tell us that we want to allow businesses or stock exchanges to decide whether they want to allow insider trading. Institutional competition would allow us to assess whether insider trading is more or less desirable given the role that capital markets perform. Historically, there is no evidence that businesses would voluntarily prohibit insider trading.

Charley Hooper writes:


You ask, if nobody lost, where did the insider’s wealth come from? It comes from the other investors, but not in a way that they are harmed, rather in a way that they aren’t helped.

Consider an arbitrager who buys boxes of computer parts for $100, thinking someone across town might buy them for $200. This person could help the seller by providing free information and pointing out the opportunity. Instead, this person takes advantage of the opportunity himself, buying the boxes. The seller was happy to sell for $100 and might not have wanted to take the boxes across town to try to get $200. The seller was not harmed in any way; the seller was simply not helped. The seller was happy with the transaction, given his/her information and preferences.

It is the same with the insider and the stock market. The insider did not hurt anyone who sold at $100. The seller was going to sell anyway. The insider simply chose to take advantage of an arbitrage opportunity, knowing that someone might pay more for those shares in the future. The seller was happy with the transaction, given his/her information and preferences.

Charley Hooper writes:

@Joe Teicher,

If you are right and bans on insider trading are designed to reduce the spreads that market makers can charge, then we could conduct a cost/benefit analysis to assess such bans.

However, if no clear relationship emerges between insider trading and those spreads, then the costs are guaranteed to be larger than the benefits because we know the costs are greater than zero.

D K writes:

Would it be reasonable to compare insider trading to market speculators, both being people who, if they make good bets, reduce the volatility in the price of commodities/stocks?

john hare writes:

I don't buy it. This is akin to suggesting that one person knowing the lottery numbers in advance, does not hurt others when buying the winning ticket. Or playing poker against someone using a marked deck is a win-win scenario.

One taking unearned profit from any transaction reduces the profit of other, legitimate buyers. Thieves do not add to the wealth of society.

robert writes:

I tend to agree that insider trading is pretty much impossible to clearly define, identify, and prosecute, and is purposefully accepted in some scenarios.

However, the cases that should still be pursued, and can feasibly, are those involving government corruption. This could be from any sort of legal or regulatory action. If a government official leaks out specific, sensitive information to an inside trader (private or not) on something upcoming that will not affect the market in order for them to make gains, both sides should be prosecuted for the insider trading crime (in addition to whatever other criminal charges may apply, as the government official may be breaking additional laws). The available evidence in such a case makes prosecution plausible as well - either there is clear documentation of behavior of the corrupt official or there isn't.

Charley Hooper writes:

@john hare,

I agree with your lottery and poker examples. I also agree that thieves destroy wealth. I'm saying that insider trading is different from these examples.

Consider the example of an insider trading before an earnings report. Perhaps the insider traded a week before the report. That's a week during which buyers and sellers would have been trading based on an assumed value of $100 for shares that were really worth $110. That's not good and it results in the misallocation of resources. The insider helps the situation by buying shares and effectively releasing a mini earnings report. By nudging the stock up to $101, the insider has helped everyone in the market because the price is closer to its true value. And those who sold to the insider had decided to do so anyway, at $100 per share. At worst, the insider allows them to sell at the price they wanted: $100. If they get $101, they are clearly better off than before.

john hare writes:

@Charley Hooper

I still disagree, respectfully I hope.

The buyers at $101 would have been able to get the shares at $100 if there had been no interference from the insider.

The sellers that sold at $101 might not have sold at $100 and would have still had the shares after the earnings report made them worth $110 so they could lose too.

This is all speculative I believe. The way I see it, the stock market is a zero sum game. In a zero sum game, anyone that takes more than they give decreases the resources for the remaining players.
If it were an increasing sum game, it would be different.

That being said on my part, I doubt that a massive witch hunt crack down on it would have any beneficial effects compared to the disruptions that would result.

Jonpez2 writes:

As Matt Levine points out, insider trading isn't about fairness to other market participants.

Charley Hooper writes:

@john hare,

If the stock market is a zero sum game, how can you explain the S&P 500 growing from 17 in 1950 to over 1,900 in 2014?

Gambling at a casino is a zero sum game. The stock market rewards most people most of the time--there's more going on there. Certainly earnings growth is part of it. Another part is resources being moved to higher valued uses, or money being moved to companies that are better investments.

john hare writes:

@ Charley Hooper

The same way I explain Vegas going from nothing to a major gambling destination.

Earnings growth, better investments, and higher valued uses are all negatively affected by people that take without returning value, as an inside trader does.

Mark V Anderson writes:

I agree with John Hare.

I am an accountant. One sign of integrity in a financial worker is that they don't take advantage of their knowledge of the firm's finances to benefit themselves. That is, fiduciary responsibility.

If I took my insider knowledge to the stock market to buy or sell stock, I would be taking advantage of current or future stockholders that didn't have my knowledge and so bought the stock above its value or sold it below its value. That is who I would be stealing from.

The stock market isn't isn't a zero sum game on an aggregate level, because it provides liquidity to those that finance firms, but if you just isolate the trading activity it is, because it consists of investors who buy and those who sell, each for the same price.

Charley Hooper writes:

@Mark V Anderson,

If, while doing your job, you came across some really great accounting software, would you consider buying shares in the up-and-coming company that made the software?

Wouldn't you realize that you had some information about that software that someone outside your firm or your industry, like me, wouldn't have access to?

And if you did invest and if the share price grew over time, who would you have taken advantage of?

AbsoluteZero writes:

"Insider information" is not any information that is not widely known. Even though there is no formal definition, as a matter of practice, insider information is information possessed only by "company insiders", and not by the rest of the company or the public. Company insiders are usually the top executives, plus often some high level technical people. It differs widely. In a smaller company even mid-level people are often company insiders. Sometimes low level employees are designated insiders temporarily. This is usually because the company has decided on an action, and some employees need to do work before the announcement. People outside the company can be designated insiders, such as people from advertising, consulting, and accounting firms.

Company insiders legitimately possess insider information, but they agree not to trade. If they do, they've broken that agreement. Non-insiders can trade, but they're not supposed to have insider information. If they do, there's usually a theft of that information. Recognizing the potential of a lesser known company is not insider trading because there is no theft of insider information. The trader is just more informed than others. Informed traders benefit at the expense of uninformed ones. Lucky traders benefit at the expense of unlucky ones.

The article by Charles Hooper, quoted by David, is about whether the ban on insider trading, as it is practiced today, makes sense. The author thinks it doesn't. Many disagree and think it's still wrong. But some of the examples given are not cases of insider trading, but more informed trading.

Charley Hooper writes:


But some of the examples given are not cases of insider trading, but more informed trading.

That was my intention to make a point. Insiders have better information. Many traders who aren't insiders also have better information. Do those who think insiders hurt others also think that non-insiders who make good trades, like Peter Lynch, also hurt others? Should the government prosecute successful investors like Peter Lynch?

AbsoluteZero writes:

@Charley Hooper,

Agreed. In fact, if becoming more informed and using that to one's advantage is somehow wrong, then all market participants, from a single individual managing a small personal account to the manager of the largest fund, are trying to do something wrong everyday. More generally, all competing companies in all industries are trying to do something wrong all the time.

And it's not just the financial markets. This is true of many other areas of life. People are always trying to become better informed and to gain an advantage over others in areas that are inherently competitive. If a parent tries to become more informed about how to get his child into a very good school, and he doesn't share what he has learned, is that wrong?

john hare writes:

@Charley Hooper

I consider informed to be a different category than insider. Insider to me is access to purposefully restricted information that is clearly out of bounds for use. Perhaps we have different bar heights or have been talking past each other a bit.

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