Insiders and Outsiders
What’s wrong with insider trading?
Photo: Massimo Mancini. Source: Unsplash
Insider trading strikes most of us as deeply unfair. If a banker passes along a tip about an upcoming deal to his cousin, and the cousin uses the information to make a bundle, we know in our guts that this is wrong. But who’s the victim? If the banker didn’t receive any compensation for leaking the information, where’s the crime?
Some legal scholars have questioned what’s wrong with insider trading in the first place. It seems like a victimless crime. It may be unfair that the someone profits because they have a well-placed relative, but lots of things in life are unfair. More information is supposed to make market prices more efficient and accurate. And market prices are used to determine lots of things, from credit-worthiness to the fair value of new firms coming to the market.
Insider trading damages the integrity of the marketplace. If outsiders believe they have less accurate information than insiders, they won’t invest. This lowers aggregate prices and increases volatility, raising the cost of capital for firms overall. Also, there’s some evidence that insider trading laws encourage innovation. In a study last year, three researchers looked at countries that started to implement strict insider trading regulations. They found a sharp increase in patent applications once insider trading laws began to be enforced.
Our insider trading laws are a mess in part because they’re based on a clause of a 70-year old law that’s been gradually refined by case law—and by some overly zealous prosecutors. Congress could clean this up and make it clear what is and is not material nonpublic information. That might make things more efficient—and more fair.
Douglas R. Tengdin, CFA
Chief Investment Officer