Cap'n Arbyte's

In Defense of Insider Trading

(This essay is an expanded version of a speech I delivered at a local Toastmasters group.)

A person trying to defend insider trading must first overcome the knee-jerk reaction of moral revulsion in his audience. Condemned by almost everyone, insider trading is likened to stealing from widows and orphans. Properly, there should be outrage over the subject of insider trading — but it should be directed against the economic ignorance of those who would restrict voluntary trades in the financial markets.

Insider trading, in layman's terms, is when a person benefits by using their knowledge of nonpublic information. Anyone can fall victim to the insider trading laws, not just company insiders, but the paradigm case is that of a company executive selling his shares shortly before a major piece of bad news becomes public. There are actually six possibilities to consider: The news might be good or bad, and the person may wish to buy, sell, or short the stock. (I ignore derivatives and all other financial instruments for simplicity; conceptually, they follow the same pattern.)

                 Buy   Sell  Short
  News is good  | A
  News is bad   |       B      C

In case (A), a person may profit by buying shares before good news becomes public and raises the stock price. In case (B), a person may avoid a loss by selling their shares before bad news becomes public and lowers the stock price. In case (C), a person may profit by shorting shares, similar to case (B).

The three blank possibilities expose a problem with the insider trading laws. Initially these cases seem nonsensical — no one would buy shares if they knew bad news was coming, for example — but these cases do make sense when they represent a person _deciding not to trade_. If you had been planning to sell some stock (to finance a vacation, let's say) but then learn of good news for the company, you may change your mind about the sale. You could carry the vacation costs on credit cards, or pay for it with home equity, or decide to sell some other stock instead. After the good news becomes public, you could then sell those shares (presumably for a fat profit) and pay off your credit cards or home equity loan or repurchase other shares. Or you could simply postpone your vacation!

When inside information causes a person to change their mind and decide not to trade, this is a form of insider trading, even though no trade takes place. Indeed, that's precisely the point. Because there is no trade, these instances of insider trading are totally undetectable and are impossible to prosecute. Laws against insider trading must automatically miss half of the theoretical space where insider trading may occur. (My understanding is that these cases are presently legal, even though they clearly violate the spirit of the law.)

The large-scale effect of insider trading is to hasten the absorption of news into the financial markets. The news would have become public eventually, so the stock price would have moved eventually. Insider trading simply makes the price move begin earlier and proceed more gradually. Graphically:

        Good News               Good News
   No Insider Trading      With Insider Trading
    |            ___         |            ___
  ^ |           /            |           /
  | |           |            |           |
  | |           |            |      ____/
  $ |   ___     |            |   __/
    |\_/   \___/             |\_/
    |                        |
    |                        |
    \----1------2---         \----1------2---
         Time -->

Time 1: Insider(s) learn of good news. Time 2: Good news becomes public, stock price jumps.

Insider trading only affects the stock price between the two indicated times, because that's the only region where there is an information difference between the insiders and the general public. The stock price before (1) and after (2) is the same whether or not any insider trading takes place.

Therefore, the only people who may be affected by insider trading are those who trade in the time between (1) and (2). Let's examine such a person.

Those who oppose insider trading claim that the insider profits at others' expense, others such as widows and orphans. The best way to deal with this misconception is to meet it head-on. Imagine two traders, one with inside information (let's call her Martha) and the other an orphan (Annie) who are both trading between (1) and (2).

The first fact to recognize in this situation is that the financial markets are enormous and anonymous. Annie knows nothing of Martha and was going to make a trade whether Martha was in the market or not. Martha's presence in the market does affect the stock price, which does affect Annie.

If Martha is buying and Annie is selling, Martha's buying pressure operates to raise the share price, thereby giving Annie a better deal than she would have otherwise had.

If Martha is selling and Annie is buying, Martha's selling pressure operates to lower the share price, thereby giving Annie a better deal than she would have otherwise had.

In these cases, where Martha and Annie are making opposite trades, Martha's presence in the market moves prices in the direction that _benefits_ Annie! Annie will be disappointed when the news becomes public, but remember that she was going to make her trade regardless of Martha's presence in the market.

If Martha is buying and Annie is buying, Martha's buying pressure operates to raise the share price, thereby giving Annie a worse deal than she would have otherwise had.

If Martha is selling and Annie is selling, Martha's selling pressure operates to lower the share price, thereby giving Annie a worse deal than she would have otherwise had.

In these cases, where Martha and Annie are making the same trade, Martha's presence in the market moves prices in the direction that hurts Annie. However, Annie will be pleasantly surprised when the news becomes public because she will still receive a large unexpected (and therefore arguably undeserved) benefit.

Annie is always happy, whether she's trading against Martha or with her! The argument that insider trading amounts to stealing from widows and orphans is a vicious lie and a complete economic and moral inversion. Those who advance it are parading their economic ignorance in the guise of compassion — it's disgusting!

It's important to understand that the purpose of the financial markets is to allocate capital to its most profitable uses. When the markets are more in-line with reality, they better serve that purpose, and raise overall production. Insider trading _improves_ financial markets by hastening their adjustment to new facts. Therefore, insider trading benefits the economic system as a whole. Insider trading is good for Martha, good for little orphan Annie, and good for everyone else, too!

There is one — and only one — case where insider trading can be damaging. This case isn't due to any defect of insider trading itself, rather it's caused by an economic "moral hazard" that can arise in a poorly-structured market. If a company insider (a true insider, not merely someone possessing inside information) is allowed to short his company's stock [more exactly: hold a "net short" position], he could profit by causing a disaster in his own company. Clearly, it isn't desirable for anyone to have an incentive to destroy capital.

Even in this case, there is no need for a law against insider trading. This situation could be handled by employment contract. For example, employees could be forbidden from shorting the company's stock as a condition for employment. The actual details are likely to be complex, but a solution by contract is clearly possible and far preferable to a law which would infringe on property rights. (I note with some satisfaction that the practice of awarding stock options substantially reduces the risk of this moral hazard by making it more difficult to have a net short position.)

Remember the following points: Laws against insider trading are powerless against half of the possible scenarios. Even in the case where insider trading may be dangerous, there is no need for a law against it. Insider trading is not only victimless, it actually improves the economy as a whole by increasing the efficiency of financial markets. For the reasons I've just stated, I advocate the total and immediate repeal of all insider trading laws. So should you.

UPDATE 2003-11-06 05:39:31 UTC: Answering the concern of a reader:

If there were no restrictions on insider trading, would insiders try to create stock price fluctuations they could profit from? Could this be a successful strategy?

In general, the profit potential behind insider trading arises because the insider has more complete and more accurate information than the general public. The profit is only realized after the information becomes public knowledge and the stock price reflects the new facts. Therefore both the status of the company and the public's knowledge of it are relevant.

An insider could only profit (not merely lessen a loss) by harming the company if they were in a net short position, which I believe it is prudent for the company to forbid of its employees. Companies would likely prohibit all shorting. Moreover, harming the company is grounds for termination, and the reputation stain ensures this is not a repeatable strategy. In my view this extends even to acts which make a company look more profitable in the short run, at the expense of the future. Stockholders are (or ought to be) wary of management that's too focused on the next quarter's results. Of course, this is a wider issue and the insider trading angle is a very small component.

If an insider cannot profit by harming the company, they could instead take actions which benefit the company and move its stock price up — but this is precisely what employees ought to do, it's what they're paid to do, and it would please the stockholders. There are no grounds for complaining in this scenario.

An alternative to affecting the material status of the company is to manipulate the information that the company releases to stockholders. It is the responsibility of management, up to and including the board of directors, to provide accurate information to stockholders. If they aren't providing accurate information, the stockholders will eventually learn of this and replace them. The accounting scandals of the past few years are illustrative. In financial transparency, too, insider trading is a very small component of a much wider issue.

Tiny Island