By Kevin Meyer
I've always considered insider trading a crime, unfair to those without the knowledge to make informed judgment calls on investments. But leave it to our friend Don Boudreaux of Cafe Hayek and a professor at George Mason University's economics department to twist traditional thinking on its head. His opinion piece in Saturday's Wall Street Journal brings up a side of the issue I had never thought about.
It's Halloween season, and the scariest demons in the world of business
are insider traders, lurking behind every stockbroker's desk and
four-star restaurant banquette. They whisper dark corporate secrets
into the ears of venal speculators, and inflict pain and agony upon
Time to stop telling horror stories. Federal agents are wasting their
time slapping handcuffs on hedge fund traders like Raj Rajaratnam, the
financier charged last week with trading on nonpublic information
involving IBM, Google and other big companies. The reassuring truth:
Insider trading is impossible to police and helpful to markets and
Uh… "helpful"?? You've got to be kidding, right? That got my attention.
Far from being so injurious to the economy that its practice must be
criminalized, insiders buying and selling stocks based on their
knowledge play a critical role in keeping asset prices honest—in
keeping prices from lying to the public about corporate realities.
Prohibitions on insider trading prevent the market from adjusting as
quickly as possible to changes in the demand for, and supply of,
corporate assets. The result is prices that lie. And when prices lie, market participants are misled into behaving in
ways that harm not only themselves but also the economy writ large.
Boudreaux goes on to support that statement with a couple of pretty good examples. Enron's a good one.
As argued forcefully by Henry Manne in his 1966 book "Insider Trading
and the Stock Market," prohibitions on insider trading prevent asset
prices from adjusting in this way. Mr. Manne, dean emeritus at George
Mason University School of Law, pointed out that when insiders trade on
their nonpublic, nonproprietary information, they cause asset prices to
reflect that information sooner than otherwise and therefore prompt
other market participants to make better decisions.
According to Mr. Manne, corporate scandals such as Enron and Global
Crossing would occur much less frequently and impose fewer costs if the
government didn't prohibit insider trading. As Mr. Manne said a few
years ago in a radio interview, "I don't think the scandals would ever
have erupted if we had allowed insider trading because there would be
plenty of people in those companies who would know exactly what was
going on, and who couldn't resist the temptation to get rich by trading
on the information, and the stock market would have reflected those
problems months and months earlier than they did under this cockamamie
regulatory system we have."
But here's the part that really got me: the impact of "non-trades." In effect, an insider is prohibited from trading… but not from "not trading." If you have inside information that other half of the trading pie can be just as valuable financially.
So, too, though, does the insider profit who, upon learning the same
information, abandons her plans to sell 1,000 shares of the company.
But because insider "nontrading" is undetectable, only the former
insider is practically subject to prosecution and punishment.
And because opportunities to profit through insider "non-trading"
might well occur with the same frequency as opportunities to profit
through insider trading, as many as half of those investment decisions
influenced by inside information might be undetectable.
This bias is not only a source of prosecutorial unfairness; its
existence casts doubt on the assumption that insider trading is so
harmful that it must be treated as a criminal offense. After all, if
capital markets continue to function as well as they do given that many
investment decisions potentially influenced by inside information are
unstoppable because they are undetectable, why believe that the
detectable portion of investment decisions influenced by inside
information would be harmful if they were legal?
That is something I had never thought of. By focusing on what is seen, there is ignorance of what is unseen and potentially a greater problem.
So does a prohibition on insider trading actually decrease transparency, allow an equal number of "non-trades" and delay the identification of fraud or other problems thereby create even greater scandals? I'm not necessarily convinced yet, but now more curious.
And the bottom line point is to challenge even seemingly-obvious ideas – there may be side you haven't even considered.
Prof Bainbridge, who has written much on this subject, fine tunes and corrects Boudreaux’s reasoning.
I don’t really subscribe to the thought that insider trading should be allowed – at least not yet – but I do have some problems with Prof Bainbridge’s critique of Boudreaux. Bainbridge appears to be arguing for the the very transparency that Boudreaux embraces by opening up the market. One of the commenters on the Bainbridge post said it well:
Your argument with Boudreaux seems wrong to me on at least three scores, though in all fairness I should acknowledge that most of the errors you make are quite common in these discussions, and economists are almost as guilty as law professors in getting this wrong.
First, your major argument for insider trading is, I think, grossly exaggerated in its significance. This is the argument that IT allows companies to keep justifiably proprietary information secret while letting the market price adjust values to the new but undisclosed information. This is so, but the circumstances in which this argument comes into play, as compared to garden variety insider trading cases, is tiny indeed. While this argument has some throw-away merit, it can hardly serve as the central defense of insider trading. That clearly must relate to the pricing efficiency notion.
However, before I get to that I want to make another criticism that I think is crucial to this entire debate and which you seem to ignore. Empirical data in this field is almost worthless! I know that is a surprising statement to apply to an area where we have perhaps the best data known to empirical economic science. But the data in all the studies of, for example, how quickly insiders’ actions are reflected in stock prices,is woefully inadequate to the task. That is so for one simple and uncontracicted reason: all data was taken from the market after the regulation of IT by the SEC was well underway. Thus, mechanisms that undoubtedly existed (Cf. the “clearinghouse function of brokers” described in my 1966 book)in an unfettered IT regime had ostensibly disappeared by the 1970s, and the dissemination of information had become far, far less efficient than it was prior to 1961 (Cady Roberts). This would undoubtedly have had considerable influence on the results of empirical tests for rapidity of dissemination. Yet most if not all the empirical studies to which you refer involve this time period and thus tell us next to nothing about the speed with which the system worked pre-1961. It is also not surprising that these studies reach a variety of conflicting results. That is the nature of the use of inappropriate empirical data.
Finally to get to your most meaty (and erroneous) argument I turn to your position that insider trading does not really help guarantee an efficient market. This you say is so for two reasons, the first being that the elasticity of demand for any one company’s stock is near zero since it is always substitutable (in diversified portfolios)for the very large number of shares that have the same Beta. Thus an insider’s transactions are generally too small to affect the price.
The second argument, which follows from the first, is that derivatlively informed trading is the kind that must necessarily account for price changes when there is IT. And since derivative trading is necessarily less “perfect” than trading with real direct information, the price will generally not be the “correct” one, but only some approximation of it.
The problem with both these propositions (and here I certainly do not want to fault you for adopting what seems to be the conventional view in the economics literature and for not noticing how inappropriate it is for present purposes) is that it all assumes a mechanism for price formation that simply does not work most of the time. Here I have reference (and this is confirmed by your misleading reference to simplified traditional supply and demand analysis) to the implicit idea that a stock’s price is formed by the marginal trader with information who arbitrages the market until the price is right.
That is standard price theory, and it even holds true in the case of a purchase of substantially all the stock of a given company (say in a takeover). But it is a far cry from reality, as I think some of the better behavioral economics now teaches us. There is clearly a different mechanism at work here, something that borrows on “the wisdom of crowds” notion of James Suroweicki, a kind of weighted averaging (nothing like the “consensus” you referred to) that results in a (miraculously?) efficient pricing scheme. Clearly there are these two mechanisms for formation of prices either one of which may doninate at any given moment. However, the latter is more likely to be operating in run-of-the-mill stock trading. Note further that the second has little or nothing to do with suppply and demand concepts and yet there is nothing in it that contradicts the findings of efficient market researchers. Insider trading long did and undoubtedly still does play a large role in keeping the stock market as efficient as it is and useful in all the ways that Don Boudreaux described.
Jim Fernandez says
One of the problems I’ve always had with insider trading is who is an “insider” and how far inside do you have to be to be called an “insider”. If the CEO and the people that run the company make decisions and then buy and sell stock just before or after their decision; yeah, I suppose they are insiders. If I live across the street from the company and I see trucks begin to deliver tons of material and then I start buying stock in the company; am I an “insider”? And then of course there are many many people in between these two examples who could be considered “insiders”.
There are people who are in some way connected with a company, employees for example. Then there are people remotely connected with companies, vendors and vendors of vendors for example. There are also people who do extensive research into companies in order to make wise investment decisions. I think Mr. Boudreaux is correct because he recognizes that all of these people provide the truth about the value of the companies. The question is how far up the line do we go when looking for illegal insiders trading.
Suppose a person were to sell all of his stock in the company he runs, and then that same person who has the power, makes a decision to close down the company. I think this is obviously criminal activity. And I think Mr. Boudreaux would agree. The clear definition of illegal insider trading would be if the person can make the price of the stock change by their actions. Somehow the definition has changed to, if the person had knowledge of something that is going to make the price of the stock change.