Is Insider Trading Harmful?

Notice that no one sues if someone uses so-called "inside information" and loses money! The inside information nugget itself does not determine the price reaction; insiders are forecasting along with the rest of us about the public reaction to the information once it becomes public. This is why the insider trading laws were so difficult to write, and why apparent violations must be tried on a case-by-case basis. I am not defending illegal insider trading. Rather, I just want to point out that there is a very fine line between trades that are and are not legal under this law, and that we only see those instances where the insider gained. I believe there are just as many instances where the insider used the information, only to lose money because the public stock price failed to react as the insider expected. The insider does not control the stock market's reaction to new information.

Isn't it a given that essentially everyone who invests believes himself to have better information, have interpreted it better or acted on it sooner than his competitors? Since everyone believes himself to be investing on such insider information, charges of insider trading are simply an accusation that one had the temerity to be correct in his assessment.

Insider trading goes on all the time. Does anyone believe for 1 second that the investment bankers and traders in an investment banking firm do not talk. Insider trading is fine for this group. The investment houses do not like the rogue insiders trading since that disrupts the business of the establishment investment banking firms. Several years ago I was structuring a transaction of a small publicly held company which required that an agreement be reached between a large shareholder and my investor. The task for reaching agreement on valuation was left to the respective establishment investment bankers who on Wednesday afternoon agreed on a price which was twice the then current price of the stock trading on the market. The next morning before all the paperwork had been filed with the exchange the price on the public market opened at the price agreed upon by the respective investment bankers. Over the next several years the price of the stock continued to climb over 1000%. I was privy to the pricing agreement reached Wednesday but was not able to trade due to insider trading laws. Apparently no such restriction applied to the two establishment investment bankers who not withstanding our agreements as to confidentiality elected to trade in the public market. Thus, ends the lesson on insider trading.

I'll go further and say that trading on inside information, even if the trading violates contractual obligations, could be beneficial and ought not be punished. The corporation may punish the insider by expelling him from the corporation or nullifying other agreements with him, but the state does no good by interfering.

Insider trading is only an issue if there's material non-public information at play. That information will become public eventually. If insiders can trade, it'll become public faster and the rewards will inure to the benefit of the insiders. If insiders can't trade, it'll take longer to become public and the rewards will be received by the large institutions/hedge funds that can react the fastest to breaking news. And in the interim the stock will not be priced as accurately.

Insider trading profits are the insider's reward for bringing material information to the market's attention faster. The market still benefits, just like the market benefits as a result of someone doing great fundamental research and trading on that.

"And in the interim the stock will not be priced as accurately."

Leading to many outsiders to unknowingly buy into an overpriced stock. That's why it is GOOD for outsiders to have insiders trade. It seems so many of these folks arguing against insider trading forget that the prices are always public.

That's ludicrous. An insider trader knows one day in advance that Apple exceeds its quarterly targets. It buy the stock below fair price; it moves the market minimally (if he does otherwise he misses his goal). The day after, he collects a hefty profit on information that would have been public anyway. In which way have the other participants benefited?

"it moves the market minimally"

At least we've gotten you to admit that it does not hurt the outsider, therefore the outsider should be indifferent to the presence of inside traders.

The next step is for you to realize that it CAN help the outsider by its effect on prices. You are right, it is a continuum--the more insider trading there is, the more the price is affected, and the more benefit to the outsider.

Insider trading profits are the insider's reward for bringing material information to the market's attention faster.

So what? The market price is nowhere near precise, due to uncertainty about earnings in out-years, and by your own admission the information would have come into the market in due course anyhow. So, what, exactly, is the insider trader doing that is worth rewarding (especially from the point of view of the "mark" the insider takes advantage of to make his profits)?

Furthermore, allowing insider trading creates a perverse incentive to corrupt public information like earnings estimates. If I'm an executive, and I'm allowed to trade on inside information, then I want earnings estimates to be badly wrong, since that enhances the value of my inside information. The net result of allowing could very well be to decrease the overall quality of information in the capital markets. The net result of that would most likely be capital flight to markets with better rules. That's pretty much what we observe today, isn't it? The premiere capital markets in the world are pretty much those that have regulations that keep crooked insiders from preying on investors.

In all of this lengthy discussion all we've really managed to establish is that there are two prominent categories of people who favor removing restrictions on insider trading. One group has read far too many Robin Hanson articles and has made a sort of religion out of the information gathering power of prediction markets. The other thinks it can profit from insider trading either directly or indirectly by observing the movements of insiders and piggybacking on their trades.

The former have a long way to go before they can claim to have a convincing argument that "bringing information to the market's attention faster" is a particularly useful goal in and of itself, and the latter will, I hope, forgive me if I suspect them of having a bit of a "bootleggers and baptists" motivation at work.

Furthermore, allowing insider trading creates a perverse incentive to corrupt public information like earnings estimates.

Well, thank GOD that perverse incentive is removed by insider trading rules or else we'd have accounting scandals like Enron, WorldCom, Global Crossing, Qwest, etc. Oh wait a minute.....

RPL, by the time statements are made public, three months have passed. Thus, the publicly available information published in reports is so stale, it's worthless for trading purposes. It's interesting how you claim that stock price is imprecise (I think you're wrong) because so many assumptions about so many variables are baked in and yet complain that a danger of insider trading is imprecise earnings estimates.

By the time the earnings estimates and all that jazz comes out, the insiders have ALREADY taken advantage of the information. You have the timing backwards.

You can't decrease the quality of information if trades carry information - and they do. You can only improve the quality of information.

The net result of that would most likely be capital flight to markets with better rules. That's pretty much what we observe today, isn't it?

Yes, but not for the reasons you think. Capital is flowing to markets with fewer dumb and unenforceable rules. The myriad of trip wires that is the SEC only serves to raise the cost of doing business in the United States and drives away capital.

You seem to be under the impression that the insider trading rule works as advertised. Nothing could be further from the truth. Insider trading happens every single day. It’s virtually impossible to prove, so it’s virtually never prosecuted. I can give you a million different ways to trade on insider information and never get caught.

As for Baptists and Bootleggers – I’m neither. I’m not in a position to be privy to insider information and it doesn’t bother me when I’m trading with an insider either. In fact, I love it because it gives me information. So, the rule or lack thereof doesn’t bother me one way or another. My goal is to make you aware that the rule doesn’t work anything like as advertised and that it’s costing you in terms of bloating the SEC budget.

Well, thank GOD that perverse incentive is removed by insider trading rules or else we'd have accounting scandals like Enron, WorldCom, Global Crossing, Qwest, etc. Oh wait a minute

I'm trying to figure out whether you are trying to argue that a law is worthless unless it can be perfectly enforced (Why do we bother to make murder illegal? People get killed every day!) or you are trying to argue that we already have all the fraud that is possible, so legalizing it wouldn't lead to any more of it. Both positions are pretty silly, so I'll leave it at that.

RPL, by the time statements are made public, three months have passed. Thus, the publicly available information published in reports is so stale, it's worthless for trading purposes.

Huh? Tons of companies are making 2009Q3 earnings announcements this week. Considering that sales for the quarter didn't close until 30Sep, and allowing time to pull together all the required data, I'd say those results are pretty timely. Certainly the information is not entirely stale, as stock prices do tend to move on earnings surprises.

It's interesting how you claim that stock price is imprecise (I think you're wrong)

Wasn't it you that accused the administration of "blowing a bubble in the stock market" recently, or am I confusing you with one of the other regulars? In any case, there is plenty of evidence that stock valuation is imprecise. Look at the variation in analyst forecasts, day-to-day volatility, or phenomena like bubbles, just for starters.

because so many assumptions about so many variables are baked in and yet complain that a danger of insider trading is imprecise earnings estimates.

Again, I'm not sure what argument you are making here. Are you saying that quarterly estimates are currently worthless, so they can't possibly get any worse, or are you saying that given an incentive to corrupt the data coming out of the company executives won't do just that? Neither of those claims seems particularly credible to me.

You can't decrease the quality of information if trades carry information - and they do. You can only improve the quality of information.

That's true, to the extent that prices are the main source of information, anyhow, but if the improvement in the quality of the information is small, and the other deleterious effects are large, then the change could be a net negative. I believe that it would be, and proponents of allowing insider trading haven't really come back with anything convincing to suggest otherwise.

Yes, but not for the reasons you think. Capital is flowing to markets with fewer dumb and unenforceable rules. The myriad of trip wires that is the SEC only serves to raise the cost of doing business in the United States and drives away capital.

Which capital flight are you talking about? I'm talking about the fact that the premiere markets are in places like New York and London, while third-world capital markets tend to be poorly capitalized.

As for Baptists and Bootleggers – I’m neither. I’m not in a position to be privy to insider information and it doesn’t bother me when I’m trading with an insider either. In fact, I love it because it gives me information.

Hmm. You should go back and listen to Russ' interview with Bruce Yandle again. I'm pretty sure you just described yourself as a "bootlegger" in Yandle's parlance.

Seriously, though, consider the extreme case where everybody in the market has access to inside information except for you. That means every trade you make would be a sucker trade. Are you really claiming that you would have no problem investing your money in such a market? If you're willing to admit that you wouldn't, then all we really have to disagree about is how large the fraction of insiders can be before a market turns into a sucker's market.

Are you really claiming that you would have no problem investing your money in such a market?

I already do (although, you have the market assessment wrong). I know that the insider trading rule is useless and yet a very substantial part of my net worth is wrapped up in my firm which uses that capital to trade. What I’m telling you is that if the rule were scrubbed off the books tomorrow, I wouldn’t pull one penny out of the market. Neither would anyone else I know in the business. Just saying – my money is where my mouth is.

I already do (although, you have the market assessment wrong).

You seem to be having trouble distinguishing between the market of my thought experiment and the market of the real world. The real-world market that you invest in is nothing like the one in my thought experiment. Your inability to imagine how the thought-experiment market would play out doesn't exactly inspire confidence in your predictions of what would happen if we changed the rules in the real-world market. If you can't solve the simple, idealized case, then your assessment of the muddy real-world case is likely wrong too.

I know that the insider trading rule is useless and yet a very substantial part of my net worth is wrapped up in my firm which uses that capital to trade. What I’m telling you is that if the rule were scrubbed off the books tomorrow, I wouldn’t pull one penny out of the market. Neither would anyone else I know in the business. Just saying – my money is where my mouth is.

You clearly believe that you have the skills to prosper in a market with no rule against insider trading, and perhaps you're right. Most of us, on the other hand, do not. We would either have to hire people like you to navigate the shoals for us (O, fortunate day for you and your colleagues), or we would have to take our investments to markets with more favorable (for us) rules. Which one would happen depends a lot on the quality of the alternatives available, how much your industry decides to charge for its services, and probably a host of other factors.

No matter how you slice it, however, there's a risk that it will all blow up, and I still haven't seen a compelling case that we would be getting something in return for taking that risk.

rpl,

your thought experiment was nonsensical. If everyone but you has information, it's by definition not non-public information. I don't wish to entertain nonsense. Also, I don't have any need to inspire confidence my prediction of what would happen. I already told you that the rule is not a hindrance to insiders.

You clearly believe that you have the skills to prosper in a market with no rule against insider trading, and perhaps you're right. Most of us, on the other hand, do not.

You labour under the assumption that you will not lose if nobody traded on non-public information. Not so. You will lose no matter what when the information becomes public. The skill is recognizing when a trade is giving you information and what the information might be. Since all trades carry information (not just insider trades), you either have to learn how to read information in a trade or hire someone like me to do it - just as you hire teachers, lawyers and doctors who have skills you don't have. Oh, woe is you.

I repeat myself: the rule doesn't protect you from anything but lower taxes and a smaller SEC budget. Insiders trade anyway - rule or no rule.

I reworded the hypothetical to avoid the use of the term "nonpublic," so I don't see why you continue to harp on that tired string. I can't help thinking you're just making up excuses not to answer a question that you find difficult. As I said before, if you can't analyze the limiting cases, then there's no reason to believe that your analysis of the in-between cases is anything more than supposition.

And now you're claiming that the reason my taxes are so high is all that money we're spending on the SEC? Really? All that money we spend on Medicare, Social Security, and Defense, and it's the SEC budget that's bankrupting us? Let's be serious.

Finally, you seem obsessed with the idea that some insiders trade in spite of the rules against it. I don't doubt that they do, but so what? Many insiders don't trade on inside information, and those that do are forced to be circumspect about it, reducing the gains from it. Your argument amounts to saying that insiders are already extracting as much profit from their information as they possibly can; there's no way it could get any worse, even if we condoned it. That's nonsense.

The claim is even less credible when you consider how much of your own information about the prevalence of insider trading is based on anecdote and guesswork. You observe certain favorable trades and conclude that they must have inside information, but you have no ground truth to confirm that against, and you've given no indication that you've done any rigorous statistical work to validate your hypothesis or to test other hypotheses. Indeed, you haven't given any indication that you have any idea how to go about such testing.

Please note, by the way, that I am not criticizing you for not having done those sorts of tests, nor suggesting that you should go do them. You sound like you make a good living doing things the way you do them, and more power to you. However, you can't expect people to take seriously your forecasts about what would happen under a certain rule change if you don't back it up with something more than anecdote.

In any case, I think we've gotten all there is to get out of this conversation. Arguing with you has helped me clarify my own thoughts on this matter, for which I thank you.

rpl, I answered your reworded question above. The answer was "yes". Was your diatribe necessary?

And now you're claiming that the reason my taxes are so high is all that money we're spending on the SEC? Really? All that money we spend on Medicare, Social Security, and Defense, and it's the SEC budget that's bankrupting us? Let's be serious.

Now, I think you're either an idiot or you're just being an ass for the hell of it. I will spell it out for you - whatever taxes you pay for the SEC's bloated budget to support insider trading headlines, you could save.

You seem obsessed with the notion that insider trading is against the law from everyone - despite my repeating myself ad-nauseam that it's not against the law for a large group of people - politicians. Insiders aren't even forced to be circumspect. They can just trade from abroad. If you have a computer, you can trade with impunity from Dubai. If you have a computer and you're a politician, you can trade with impunity from Maryland. Now, please tell me again how this rule is protecting you from the big bad world.

I am giving you anecdotes and anecdotes is all you'll ever get because nobody is going to 'fess up to an insider trade and deciphering which trades are for sure driven by insider information and which aren't. That is also the reason that the SEC can almost never get an insider trading conviction.

You act as though the rule always existed and exists everyhwere. Compare the markets before and after the rule, normalizing for other changes.

You're right. We've gotten all that we're getting. I get a lot of insight about how people think from discussions like this. They are very valuable to me, so I thank you.

"and deciphering which trades are for sure driven by insider information and which aren't....is impossible."

Seriously, though, consider the extreme case where everybody in the market has access to inside information except for you.

That makes no sense. If the whole market has the information except for you, then it is by definition not inside information.

Consider the extreme case where everyone in the market is smarter than you or more educated than you or has a larger research department than you or subscribes to an influential investing newsletter that you don’t know to subscribe to. There are lots of disadvantages I can imagine that yield the same information asymmetry as insiders trading.

That means every trade you make would be a sucker trade.

No, it doesn’t. I trade for a living. I see insiders all the time. Every trader I know sees insiders. Ever wonder why a stock will sometimes suddenly drop half an hour before an announcement? It’s not an infrequent event for a stock price move to precede the actual announcement. If every trade I made was a sucker trade, I would have been out of business years ago. That’s my other point. Market participants learn how to deal with trades they suspect are insider trades – they simply factor in the information. If people aren’t lulled into a false sense of security that the guy on the other side of the trade doesn’t have better information, more people would learn to move their market when they see information revealed in an order and insiders would benefit less from the inside information. The information would be revealed sooner and the price would move to fair value faster.

That makes no sense. If the whole market has the information except for you, then it is by definition not inside information.

You're going to quibble over that? Really? Here, let me fix it for you:

Consider the extreme case where everyone in the market has access to a company's true earnings except for you, who must rely on forward-looking estimates. Would you be willing to trade that company in that market?

It is easy to see that every trade you make in such a market will be a sucker trade because everyone else has a better estimate of the stock's true value than you do. Therefore, they can look at any trade you offer and decide whether you are making a valuation error in your favor or in theirs. If the error is in your favor, they won't trade with you. If it's in theirs they will. Thus, you only get to trade if the trade is a sucker trade.

In a market where only some traders are insiders, your probability of getting being a sucker on any given trade is proportional to the fraction of traders who are insiders. If it's low enough, you can ignore the effect. If it's too high, you get out of the market. When outsider traders get out of the market, that raises the fraction of insider traders, which creates a positive feedback. Therefore, we expect insider trading (and other forms of corruption, for that matter), to show threshold behavior. Below the threshold, nobody notices, and outsiders can profit in the market, as you report you have done. Above it, outsiders can't profit, and they flee the market.

American capital markets are manifestly below the threshold where everybody flees. Asian markets are too, despite having more corruption, because Asian economies are growing so rapidly. Higher returns raise the threshold because your losses on sucker trades can be washed out by the secular growth trend.

You are suggesting that we move the American markets closer to the threshold, but you assure us that we won't accidentally cross over it. I'm not convinced, and I don't see much in the way of benefits on offer for taking the risk.

Consider the extreme case where everyone in the market has access to a company's true earnings except for you, who must rely on forward-looking estimates. Would you be willing to trade that company in that market?

Yes. I even already told you how to handle that. Only an idiot would continue to make sucker trades. And there's no shortage of idiots.

Below the threshold, nobody notices, and outsiders can profit in the market, as you report you have done.

meh. It's only subject to some kind of threshold if people know how prevalent it is. The main reason that the SEC can almost NEVER get a conviction is that insider trading is almost impossible to prove. Thus, while it happens all the time, few people are all that aware of it. And I repeat - ALL POLITICIANS CAN AND DO TRADE ON MATERIAL NON-PUBLIC INFORMATION. So, for some, there is no rule at all.

The threshold isn't the number of insiders who can trade on non-public information. After all, there were no insider trading rules during the 1929 crash, yet insiders didn't avoid the crash. The threshold is how much market moving (market in the specific stock) insider information there is compared to all other information. Only surprises move markets and surprises, by definition, are few and far between.

Consider the extreme case where everyone in the market has access to a company's true earnings except for you, who must rely on forward-looking estimates. Would you be willing to trade that company in that market?

Some clarification on why I would still be willing to trade in that company's shares: If everyone else has all the information and I don't, then I can safely assume that the information that everyone else has is reflected in the price of the stock as they not only trade with me but also each other.

That's what makes this scenario not analogous to trading on material non-public information and makes it kind of a useless thought experiment when thinking about insider trading.

I'm trying to figure out whether you are trying to argue that a law is worthless unless it can be perfectly enforced

I’m saying that the law has no value except to the corrupt state – which enjoys imprecise laws so that it always has something to threaten people with. It is worthless if it can neither be enforced nor prosecuted once the law is broken. I’m trying to disabuse of the notion that you are receiving some benefit from this useless law.

Tons of companies are making 2009Q3 earnings announcements this week.

By the time the bean counters finish checking the numbers (even before they begin), the officers of the company already know what’s going on and the information is very stale to insiders by the time it gets to market. Stocks bounce around after a surprise announcement. So what? They would also bounce around if an insider traded on that information three days before the release – and everyone would know why. You asserted that there is an incentive to put out false information if insiders were allowed to trade on insider information. I can’t understand why you would think that. I’m assuming you mean insiders who are directly employed by the firm. Politicians can trade on insider information all they want and it’s perfectly legal. And they do.

Wasn't it you that accused the administration of "blowing a bubble in the stock market" recently, or am I confusing you with one of the other regulars?

Yes, I did. But, that doesn’t mean the stock price is not precise. It precisely measures the value that the market assigns to the company at that moment. And that’s all a stock price ever is.

Again, I'm not sure what argument you are making here.

Just pointing out an inconsistency in your thinking. You can’t complain about how imprecise stock prices are and then complain that an ESTIMATE may be imprecise because of some imagined benefit to insiders. Estimates are imprecise by definition. They’re just guesses.

to the extent that prices are the main source of information, anyhow, but if the improvement in the quality of the information is small, and the other deleterious effects are large, then the change could be a net negative. I believe that it would be,

Prices are the main source of information. They continuously tell you where all the various participants value the security. Again you seem to labour under the assumption that you are protected from some deleterious effect of insider trading. Insiders trade every single day – in the case of politicians, perfectly legally. In the case of foreigners, with impunity and in the case of Americans living here, largely undetected. Continuing to close your eyes to reality will only hurt you.

I'm talking about the fact that the premiere markets are in places like New York and London, while third-world capital markets tend to be poorly capitalized.

You make the assumption that capital flows there because of stupid and unenforceable rules. Capital is now flowing out of both NY and London and to places like Hong Kong and China. Trading companies are following. Liquidity is being sucked out of London and NYC and into Asian markets. I don’t know if that’s what you mean by “third world”, but third world markets like Pakistan have many much more impressive issues than insider trading.

I'm pretty sure you just described yourself as a "bootlegger" in Yandle's parlance.

Why? Because once the insider makes the information public, I take advantage of it instead of soiling myself? Do you refrain from acting on public information?

It is worthless if it can neither be enforced nor prosecuted once the law is broken.

Obviously, but you haven't established that that is the case. Your claims that "everybody does it" smack a little of hyperbole. All you've really shown is that some people manage to skirt the law, but we all knew that.

By the time the bean counters finish checking the numbers (even before they begin), the officers of the company already know what’s going on and the information is very stale to insiders by the time it gets to market.

So, not "three months," then?

You asserted that there is an incentive to put out false information if insiders were allowed to trade on insider information. I can’t understand why you would think that.

I don't understand why you don't understand why I think that. If I'm in possession of a company's real earnings figures, and all anyone else has is the forward looking estimates, and if I'm allowed to trade on that information, then I can make a killing if the estimates are wildly off. Therefore, it's in my interest to mislead the market about my company's earnings right up until the real numbers come out. Is this really so hard to grasp?

Yes, I did. But, that doesn’t mean the stock price is not precise. It precisely measures the value that the market assigns to the company at that moment. And that’s all a stock price ever is.

So, you're telling me that the stock price is a precise measurement of the price of the stock (that being the name we use for "the value the market assigns to the company at the moment"). I guess I can't argue with that.

You can’t complain about how imprecise stock prices are and then complain that an ESTIMATE may be imprecise because of some imagined benefit to insiders. Estimates are imprecise by definition. They’re just guesses.

First, I didn't "complain" about the imprecision of stock prices. I observed that stock prices are inherently imprecise measures of value (in the same sense that the readout on a scale is an inherently imprecise measure of weight). Because of that, beyond a certain point it's a little quixotic to obsess about getting information factored into the market price faster. At some point other things become more important.

Second, yes, estimates are just guesses. Nevertheless, some guesses are better than others. Creating an incentive for company executives to deliberately make those guesses worse is not a great idea.

Prices are the main source of information.

Clearly not, or prices would be unable to change. Prices are a distillation of all the information percolating around in the marketplace. As such, they are only as good as that information. Provide an incentive to manipulate that information, and prices will be manipulated right along with it.

You make the assumption that capital flows there because of stupid and unenforceable rules. Capital is now flowing out of both NY and London and to places like Hong Kong and China. Trading companies are following. Liquidity is being sucked out of London and NYC and into Asian markets.

If you're right, then the problem should soon fix itself, and there's no point in arguing about it. Personally, I think the flow of capital into Asian markets has more to do with the huge growth there, which makes it profitable to invest there even if the game is largely rigged. When Asian growth levels off to rates more comparable to Western levels, I expect we will see either a change in their rules or a flight back to Western markets. If we watch and wait long enough, then we will know for sure, and I'll be the first to admit it if the facts prove me wrong. Will you?

Why? Because once the insider makes the information public, I take advantage of it instead of soiling myself?

Wow, you clearly have no idea what I'm talking about when I say "baptists and bootleggers." Forget I mentioned it; it's not central to the point anyway.

Obviously, but you haven't established that that is the case. Your claims that "everybody does it" smack a little of hyperbole.

Everybody isn’t privy to market moving material non-public information, so that’s not the claim I made. You should read and attempt to understand more carefully. Just to help you out: “We see it every day” is not the same as “everybody does it”.

That I can’t prove it to you is the whole point. That’s why the SEC can almost never get an insider trading charge to stick. But, you explain to me why a stock tanks 30 minutes before the earnings are released if material non-public information not behind the trades?

So, not "three months," then?

Split hairs much? Way to miss the point. You don’t realize that 3 seconds after information hits the ears of anyone with the ability to write an order ticket, it’s stale as day old bread, do you? You don't seem to know that companies report earnings 1.5 to almost 3 months after the quarter closes.


I don't understand why you don't understand why I think that.

I understand why you think that way – you don’t understand the way the process works and you’re having a difficult time grasping the concept. If you’re allowed to trade on non-public information and you do, nobody gives a crap what comes out of your mouth about earnings estimates anymore – by trading, you’ve already told the market what your earnings will be. You no longer have the power to mislead people with your jibber jabber. That’s what everyone is talking about when they say “insiders bring the information to the market faster”. The real come out as insiders trade to take advantage of the information asymmetry. It gets factored into the price before the earnings release. The earnings release just confirms the price at that point. Got it?

Second, yes, estimates are just guesses. Nevertheless, some guesses are better than others. Creating an incentive for company executives to deliberately make those guesses worse is not a great idea.

Well, I just pointed out to you that lack of insider trading restrictions doesn’t do that. Company executives already have the incentive to fudge earnings estimates and regularly do that! They change estimates based on whatever they think will be most helpful to them. Some think they need to outperform estimates and regularly underestimate earnings. Some think they need pie in the sky estimates to pump up stock price (AT&T and WCOM come to mind) and regularly over-promise. Insider trading rules aren’t giving you better estimates.


Clearly not, or prices would be unable to change. Prices are a distillation of all the information percolating around in the marketplace. As such, they are only as good as that information.

No. Prices are the main source of information. New information doesn’t come out every moment of the day for stocks. Yet, prices change. Prices convey both information that may affect the stock and also people’s opinions. An opinion is also information – and the only way to convey an opinion is by transacting at a price. Thus, prices carry all information and they convey it in real time. When a price moves sharply, the first question out of a traders mouth (right after “son of a bitch”) is “what’s the news?”. Price is most often the first indicator of news. If you get news before the price moves, you are one lucky SOB! That’s the dream – which, btw can happen without insider trades.

When Asian growth levels off to rates more comparable to Western levels, I expect we will see either a change in their rules or a flight back to Western markets.

Rules will always change. For the better or for the worse is the question. However, Asia seems to be learning which rules strengthen the market and which rules are just a waste of time. The United States is looking into regulations that would significantly impede liquidity and price discovery. American firms are moving to Asia because of that and some are dropping out of the U.S. exchanges entirely. FINRA lost something like 2,000 member firms over the last year. U.S. exchanges are fighting with the SEC because they’re also losing members. Foreign companies don’t want to list in NYC because useless SEC rules make it too expensive – Sarb-Ox is a large culprit. So, I don’t agree that it’s all Asian growth related.

If growth rates become equivalent, why would capital return to a market with rules that cost everyone money but don’t have the desired effect? I don’t understand your logic.

Wow, you clearly have no idea what I'm talking about when I say "baptists and bootleggers."

I thought I did, but maybe not.

Taking away the cost/benefit analysis from purely a financial perspective, society demands justice. Sure we had the World Com, Enron, Global Crossing, BUT we prosecuted those dastardly folks. Society demands a level playing field or capitalism can't work.

Are doing the devil's advocate thing again?

Not really - I just think that there has to be a balance between freedom to act on information and fraud protection. I think it's plain unethical for an insider to know about some really horrible info that will cause the stock to tank, sell all his shares and let everyone else take a bath. That's the scenario I want to protect against.

So, you think they should fall on their sword. They don't - even with the rule. You know what else is unfair? If you have a car and can evacuate in advance of a hurricane. You should be be forced to drown with everyone else. Know what else is unfair? If you have an IQ of 120 and someone else has an IQ of 86. They will never be able to achieve as much as you and earn as much as you. It's not fair that you unfairly benefit from your genetic predisposition. Etc.

BTW, you keep tossing "fraud" around. You have yet to establish that insider trading is fraud. "Isn't it obvious" is not a supporting argument.

Also, you should know that "the people" don't want justice. The want bullshit, which they call "justice" to make themselves feel better about bullshit.

Finally, Viking, as usual, asks a good question.

"unethical for an insider to ... let everyone else take a bath."

In what way does a potential insider trader have any control over whether or not everyone else takes a bath?

When has the "playing field" ever been level?

Have you been paying attention?

Politicians can legally trade on insider information.
All the SEC rules ever do is tilt the playing field - away from retail traders. The funniest thing is that retail traders are convinced that the myriad of rules absolutely protects them. And it does - it protects them from a more efficient market with lower transactions costs. No matter how many times they are told this, they just can't wrap their heads around it. So, good luck with all that.

By level playing field, I mean don't commit fraud and deceit against your shareholders by faking the accounting numbers. Meaning, don't pull an Enron and say you're just playing capitalism. Capitalism only works when the government enforces contracts.

Did you forget what thread you're on? We're talking about insider trading, which as feck all to do with fraudulent accounting.

BTW, the interesting thing about Enron is that a sell-side fixed income analyst blew the lid on the whole thing using publicly available information which Enron disclosed in its quarterlies filed with the SEC and the other analysts and all those diligent "average investors" simply ignored quarter after quarter. Oh yeah, insider information is what's hurting people.

It's just plain unethical for the shareholders to take a bath but the insider to make a killing. Everyone should have to take the loss equally. An insider has an obligation to announce the bad news, allow the share price to drop then sell. It's only ethical.

The outsider shareholders take a bath NO MATTER WHAT. But, if the insider trades on his knowledge, the price changes SOONER, other shareholder become aware of the loss sooner, and many outside nonshareholders are spared the grief of buying an overpriced stock.

What you are saying is that you don't care as a shareholder that you lose money, just so long as nobody wins money, even though it has no effect (or rather only good effects) on you. Sounds like an argument from envy at the expense of self-interest.

Your analysis is flawed because it ignores the possibility that the unknown information might help the outsider investor (e.g., the effect of the unknown information is that the stock turns out to be worth even more than he thought it would be).

When you include that possibility, as long as everyone has equal access (or lack thereof) to the information, then the average investor should win about as often as he loses. However, if you allow insiders to trade on nonpublic information, the average investor can expect to lose more often than he wins because insiders, by assumption, never take the side of a trade that the nonpublic information indicates will be a loser. In the limit that the market becomes dominated by insiders, the (now quite rare) outsider loses every time he trades. He might still make a profit in the long run because of long-term appreciation in the securities he buys, but the insiders' take erodes his profits. All else being equal, he would be better off in a market that didn't allow insider trading.

he does announce it - through his trade.

Yeah he makes a killing, the stock plummets and everyone else takes a bath! Now you will say that insiders should have first dibs?

Is he reacting to the market, or controlling it? If he's controlling it, why would he make it go down? If he's reacting to it, then what makes you think you have a chance whether or not he trades? You will be stuck with the lower price whether it happens tomorrow because he didn't trade, or today because he did.

Um...no. He hits the bid. The market moves down. He hits again. You have now just been alerted to new information in the market. Anyone with half a brain will look at his size and his willingness to step down and move his bid down or sell with him. Or buy puts (as I said, the insiders usually go to the options market). This drives the price to fair faster.

What if I did an analysis and through mosaic theory figured out what's going on. I short the stock based on my analysis. You just bought because your retail broker said it's "a great little stock". You get hosed, I win. You assert we should all burn or make money equally. Are you saying I don't have a right to my winning trade?

What we're really talking about is the kind of accounting fraud that went on at Enron, where the executive simply plundered the company while defrauding the shareholders.

That's not what we're talking about and given what you said about it, I don't think you actually know what happened with Enron.

Not sure insider trading should be barred or not. On one side, it makes information public sooner. Markets would be more efficient. On the other side, it could give unfair (in the sense of asymmetric) advantage to a subset of speculators, based on their connections and not their skills. The information asymmetry could also create Moral Hazard, discouraging large segments of investors from taking a position in the market. The arguments against Insider Trading are not very compelling, though. "Insider Trading restrictions are bad because they were enacted recently" (Methinks): if anything, the market has become more efficient, as regulations on IT have tightened. "Politicians are the ultimate insider traders" (Methinks): a good argument to get rid of them, not of IT restrictions. "Leave trading to insiders" (Randy): I know a few portfolio managers, definitely insiders, and they would be upset if they were beaten by someone whose skill is to have connections to Robert Moffat. "Insider trading is legal for corporate execs" (GPHanner): not true, and they are very careful to exercise most of their options on a fixed schedule, or in correspondence of certain events (illness, divorce, departure from company).

On the other side, perhaps surprisingly, not all insider trading results in excess returns. This is what Smith and Eckbo find in they J.Finance paper on "The Conditional Performance of Insider Trades". So, why worry? Also, I suspect that many public companies would institute codes of conduct that forbid the employees from trading in the stock or giving information to third parties. Finally, there are studies (in Finance again) that show that the cost of equity of IT is zero. I am just saying that this is not a black-and-white issue. It's easy to have on opinion, but hard to have a well-thought-out one.

I once read a long survey on IT, in Encyclopedia of Law and Economics. The author was Stephen Bainbridge, who is specializing on the subject. The Econlib survey is good too.

"The information asymmetry could also create Moral Hazard, discouraging large segments of investors from taking a position in the market."

Why? If I am not on the inside, how does the insider's advantage hurt me? If I measure success by my return in the market, it can only help me. Why would it make sense for me to measure success by my return relative to that of an insider?

Regarding a no-trade equilibrium, in which some players just sit out the market: this is similar to Akerlof's market for lemons.

Not having insider information hurts the average investor in that any deviation from the more accurate price known to an insider can be arbitraged away by the insider. The advantage *does* hurt you.

What's at issue is whether this advantage results in better overall and long-term functioning of an exchange. I don't see it addressed in the posts below.

Asymmetric information is a permanent feature of markets. Inside information is only one example of asymmetric information.

Lack of inside information is only one thing that hurts the average investor. Lack of understanding of markets, not availing oneself of publicly available information, inability to decipher publicly available information, bias and general stupidity also hurt the average investor. Any advantage hurts the person who does not have it. Why the laser focus on inside information?

The insider trading rule wasn't even around before the 1960's. I don't remember anyone sitting out the market because it didn't exist.

Methinks, you are objectively misinformed.

Insider trading rules predate the 60s. If anything, as the rules have been enforced, markets have become more efficient in the past 30 years. It's an established and uncontroversial fact.

What is at issue is not what hurts the average investor, but what makes an equity market work better. We could design a market in which all sort of insider trading is allowed, and in which some participants cannot, even if they want to, compete with other participants. The net effect is that uninformed participants will drop out of the market. This is goes against one of the benefits of a security market, which is to enable risk sharing. In fact, if participants cannot distinguish between informed and non-informed counterparties, a very likely equilibrium is complete no-trade, as in Akerlof's Market for Lemons.

"me participants cannot, even if they want to, compete with other participants."

Why do you view this as a competition? When I trade, the only person I'm competing with is my hypothetical self in the alternate scenario that I did not choose. I don't care if you get richer than me because you have insider information, or because you are a market genius, or just because of dumb luck. That is not to my disadvantage. I don't know what might cause a price to drop, so I'm not going to have the knowledge to get out early whether you are an insider or not. But if you ARE an insider, and you do get out, then at least I may know today instead of tomorrow what my own losses will be.

Giuseppe,

I'm unaware of the rule existing before the 1960's. Do you have a link?

The rule is not enforced. It's virtually unenforceable. The existence of the rule and market efficiency are correlated, but you need more than than correlation to prove that the rule caused the efficiency. If the rule was around since before the 1960's, then why did the markets become more efficient only over the past 30 years? You think that maybe ECNs had a much bigger effect on efficiency than some unenforceable and unenforced rule?

Interestingly, the hypothetical market you describe is the actual market we have now. Some people aren't allowed to trade. Some people are legally allowed to trade on insider information and since the ability to enforce the rule or prosecute violators is almost nill, the upside to trading on inside information is much higher than the downside, so it's done all the time. Yet, the uninformed don't drop out. Why? I think it's hubris. Even the incredibly uninformed think they are smarter than everyone else.

My point in my original response to you is that a great many people are uninformed about a great many things in the market. Information is asymmetrical and people don't drop out. that was true before the insider trading rule and it's still true now because insider information is not the only information that is unknown by certain participants.

I hate to quote myself, but in a previous post I mentioned a survey by S. Bainbridge. It also offers rationales for and against restrictions that are a tad more subtle than Boudreaux' blanket statement. Wikipedia has a history of previous regulations. The Concise Encyclopedia article on Econlib also has similar information.

I am not implying that the rule caused efficiency, but that enforcing it has certainly not hampered market efficiency. And we are not discussing whether the rule is perfectly enforceable or not. If you ask Bob Moffat, he'll tell you that it certainly is. What we are discussing is whether Insider Trading is right or not.

The fact that people have and/or process information differently is no reason to deny the effectiveness of IT banning. They are playing, at least in principle, on a level playing field, and that guarantees that they are not purchasing lemons, in Ackerlof' s terminology.

Giusseppe,

I agree that the rule hasn't hampered market efficiency - much. Since we don't know how much more or less efficient the market would have been within this period without the rule, it's hard to say for sure. There is not that much market-moving insider information in the first place. Second, the rule doesn't seem to be hampering insider trading all that much anyway. Finally, there have been much more important developments to make markets more efficient - computers, for instance.

As for Bob Moffat, we'll see if the SEC has enough evidence to make the charge stick. It usually doesn't.

Is the rule right? Insiders bring information to market. What people object to is the fact that they financially benefit from doing so. I don't think benefiting from serving the market what it demands is "not right".

Since the rule is pretty ineffective at preventing insider trading, I don't think we can reasonably conclude that that people are guaranteed to not buy lemons because it exists.

I think it's a complicated issue as it deals with the issue of defrauding investors. I just don't see how insider trading isn't fraud against the shareholders.

I don't see how it is. Make the case for fraud.

Isn't it common sense that it's fraud?

No. But, if it is, you should easily be able to cobble together an argument. Go ahead.

Well, I am a Porsche employee and I sell you a 6 month Porsche 911 looking brand new and with a mileage of 2000miles for a price you're willing to pay for that vehicle,
but I forget to tell you that the engine is in fact 8 years old and has run about 400.000miles, most of them on our race track-
you only find out that two hours later when the engine explodes, and the porsche dealership denies you warranty because the broken parts are all way too old.

I guess you will not feel defrauded but instead you will be delighted that a new price discovery has been made available to you by my selling action.

I am sure you will not come back to me threatening to taking me to court for selling you something without informing you of the relevant facts. You don't like these kind of laws anyway.

If I am the Porsche CFO calling you after market closing informing you that Porsche will announce tomorrow a record profit - twice as much as analysts expect- , and I offer you a small packet of shares at market closing price because I need the cash to meet a margin call in an Asian investment, and I need the money when Tokyo opens.

If you accept to buy, you will be delighted when I announce the next day at 2pm the biggest and most unexpected loss in the history of German car making and that Porsche AG is de facto bust.

Sure I did not defraud you, I was just informing the market faster than bloomberg can.

incidentally, as far as I'm aware, the SEC has never been able to make the case that insider trading is fraud - even though it has tried numerous times.

Your porsche sale is not analogous to an insider trade. In an insider trade, by trading the insider gives up the information that the car is a lemon. That's the whole point. It's more disclosure, not less.

Moreover, people sell shares of stock to each other all the time without insider information. If the stock tanks after the buyer bought it because of some news that had not yet hit the tape when the seller offered it, by your logic the buyer was defrauded. The porsche had a faulty engine, but the seller didn't know. Can the buyer of the stock sue the seller? No. Can buyer of the porsche sue the seller. I think so.

Your second scenario....that's not how insider trades work. Insiders enter orders in the open market. Privately calling me does not. But if they did happen the way your describe, I wouldn't trade with you because I am not a moron. What idiot would offer me shares at the closing price when the company is on the cusp of announcing news that would send its stock skyrocketing? Why is he not seeking to profit from this news? Why isn't he trying to buy calls instead or asking me to sell to HIM at the closing price? a half-wit would smell this rat. No trade. And actually, I would probably hang up the phone and short the stock. You inadvertantly gave up the information (that Porsche is bust) even though the words tumbling out of your mouth are saying exactly the opposite. Actions speak louder than words, Gecko. That's why the actions of insiders in the market carry so much information.

"fraud against the shareholders"

That all depends upon the charter, as Don said.

You should not pay executives salaries or bonuses you should pay them with access to privileged information and that this information should be freely tradable to the highest bidder... is this what you say Professor?

In your 2003 article you write “Another benefit of insider trading is that it lessens the need for corporate whistle blowers. The reason is that insiders who know that a corporation’s management is engaged in accounting fraud or some other shenanigan that artificially gives a temporary boost to the firm’s market value can benefit by selling the firm’s shares short.”

And I wonder whether you believe that someone who knows that management is engaged in accounting fraud needs the incentive of being allowed a little inside trading in order to come forward and, if so, can’t we find more transparent bounty schemes?... and let the whole society participate in it and perhaps get some economic growth out of it?

There seems to be a number of arguments for legalized insider trading, but one of my favorites was stated in Don's 2003 article:

Those who doubt the benefits of insider trading need not fear the less-restrictive regime proposed here. Corporations would obviously retain the right to not tolerate insider trading within their own company. If insider trading is as harmful to investors as some people believe, investors would flock to corporations promising such restrictions. By allowing insider-trading terms to be a dimension in which corporations compete for equity, we would more surely discover when, and just how, insider trading might be detrimental. But my guess is that few, if any, investors would demand such restrictions.

According to this report, U.S. senators on average beat the market by 12% a year. In sharp contrast, U.S. households on average underperformed the market by 1.4% a year and even corporate insiders on average beat the market by only about 6% a year during that period. A reasonable inference is that some Senators had access to - and were using - material nonpublic information about the companies in whose stock they trade.

And it's perfectly legal for politicians to trade on inside information. It's just not legal for you and me to do this.

How can we claim that this law is strengthening the markets when it is practically impossible to apply and when entire segments of the population are exempt anyway?

When I trade, I want the share price to be as accurate a reflection of the company's value as possible. It seems to me that insider trading greatly facilitates that, since insiders have more information than I possibly can. It therefore exposes some of their information to me in the form of the stock price. So it only helps me. Prohibitions are probably just based on some irrational notion of unfair advantage, as though trading is some kind of race with one winner.

not only price, but size. Prohibitions are based on scapegoating and the need for the SEC to appear to be doing something useful.

"but size"

Good point.

Don normally presents an example so absurd, using the statist's logic, that he completely destroys their arguments in just 1 paragraph.

That isn't the case here and it isn't the case in his 2003 article he refers to.

Perhaps someone in the discussion will manage to do that, otherwise, I'm not convinced.

That should be FWIW... argh.

FWIF, insider trading is not illegal in Canada. However, all insider trades need to be disclosed on a system called SEDI (www.sedi.ca).

Stop insider non-trading!

For a change, I disagree with Don Boudreaux. Insider trading isn't simply trading on better info in these cases. It's manipulating the market and screwing those w/o inside info.

IMO it would not be a good idea for most people to become heavily involved in American financial markets at this point, because of the corruption involved.

Now on an entirely different subject, my real reason for posting here is that I've just heard that Don Boudreaux has won the Szasz Prize, and he deserves a hearty congratulations and round of applause for his excellent work! Hip-hip-hooray!

Not a big deal for long term holding of a diversified portfolio.

bradex 4 hours ago
From twitter via BackType
"インサイダー取引は有害か？" http://idek.net/aOi 市場を効率的にするという説は説得性があるけど、具体的に理解するのは難しい。参) http://idek.net/aOm http://idek.net/aOo

bradexさん、
参考のリンクどうもありがとうございました。勉強になりました。

Insider implies outsider. My question is, who wants outsiders in the market and why? I ask, because it seems to me that the outsiders are simply gambling, and I don't see how its a good idea to participate in state sponsored gambling. So leave investing to the investors, and the state has no role at all.

"so leave investing to the investors"

That's what most outsiders do. So most outsider investing really is "insider" in the sense that they go through investment professionals.

That was the theory. The idea was that I was hiring an insider, but it turns out all I was really hiring was a salesman. To me, an insider is someone who actually understands the activity that he or she is investing in. I don't think that can be said about someone who throws money at numbers. Seriously, my fund contained over a hundred entities. How could any such intermediary be an insider in all of them? Turns out I wasn't gambling on an insider, just gambling on another gambler with a good track record.

There are insider trading laws now. But if they were removed, those guys would have an incentive to solicit insider information. Or rather, those guys who were adept at acquiring insider information would be the one's most successful in the business.

Interesting topic. Is this not similar to the question if corruption is harmful? If I pay an official [under the table] to speed up my paperwork, it enhances efficiency. I got the paperwork done, say my permit, I can start my work sooner, create jobs sooner, and thus corruption can be efficient and make everybody better off.
If I remember correctly, Daron Acemoglu and co-authors have papers related to this effect.

Corruption is efficiency enhancing if it doesn't encourage even more corruption.

Is this the cue that most people are 'inside traders' in some fashion? If 'Bill Gates Jr.' wanted to get into the OS software business he's far ahead of someone whose father isn't already into the OS software business. If 'Arnold Schwartzenegger Jr.' wanted to get into bodybuilding he'd be far ahead of someone whose father hadn't a clue about exercising. If 'Joe Average Plumber Jr.' wanted to become a plumber then his father could point him into the right directions. And so forth. A great many people have access to choice information that puts them far ahead in a particular field that isn't easily avialable to the public.

If all insider traders could be jailed, there would be many people in prison, starting with politicians and officials.

Insider trading is legal, otherwise corporate execs and board members would have a hard time selling their shares, not to mention the "specialists" at NYSE, et al. The hook is that it has to be reported to the federal government.

How are specialists insiders?

The specialist can see how the buy and sell orders stack up, and he is allowed to transact for his own portfolio. That information is known only to him, making it "inside" information in a broad sense.

The fact that specialists used to control the book is a fair point. Transacting for their own portfolio was strictly regulated. They really couldn't hog all the good trades. It did create an information imbalance though. I wouldn't call it "inside" information - whatever that is.

True.

Insider trading is NOT ILLEGAL for politicians.

That's right.

Politicians can LEGALLY trade on inside information.

Methinks, can you elaborate on this? Interested to know.

There's nothing to elaborate on - it's as outrageous and straight forward as it sounds. I didn't even know this until Vidyohs asked me about it and I had to go and do some research.

http://steadfastfinances.com/blog/2009/09/22/in...

http://www.securitiesdocket.com/2009/03/11/clos...

They truly think they're feudal lords in congress.

Thanks for the link, and glad more people are becoming aware of Senators & Representatives playing Fast Money traders when they get bored with writing laws.

Unfortunately, there are lots of people who make money on insider trading within the Beltway. How can we expect Congress to fix healthcare or balance the budget, when they can't even stop themselves from committing a financial transaction that would be illegal anywhere other than Capital Hill.

I can understand why they don't want to give it up...

1) The potential gains, if you play the options market, can be in the >500% or more if you know something really juicy and get in way before Wall Street gets a whiff.

2) What Joe Public doesn't know about won't hurt him. It's just another instance where we believe politicians have enough ethics to self regulate themselves, or we're too caught up in American Idol to give a darn.

The ironic thing is that politicians do not have to disclose their portfolio holdings, but are fighting the financial companies to increase their transparency. Even more ironic, is that most of the commentators who work at CNBC are required to invest in index funds only for fear they might know something the public doesn't.

Which begs the question... isn't it funny we hold a person who reads a teleprompter to higher financial scrutiny than a United States Senator.

And yes, I firmly believe insider trading hurts the financial markets.

Yes, well, insider trading for some and not for anyone else hurts it even more.

Interesting. I was under the impression that legislators had to have portfolios they couldn't see inside (can't think of the term right now).

This supports the efficiency enhancing theory of why insider trading is illegal. It's because insiders want it and may have even lobbied for it, not that legislators are looking out for the interests of the common investor.

Blind trusts. I'm amazed legislators can invest in anything else.

Those bastards never stop amazing me.

Well-said.

Insider trading makes the market efficient at what? Your link suggests that the answer is price discovery ("Perhaps the greatest benefit of insider trading is that it causes equity prices to disclose all relevant information as quickly as possible."), but is that really the purpose of capital markets? I would argue that the real purpose of capital markets is to allocate capital, and in order to perform this function investors must be willing to put their capital in the market to be allocated. If would-be investors know that they face an information deficit relative to insiders in a capital market (and that insiders will be allowed to exploit that deficit), they are going to be reluctant to invest in that market; they will seek a market with stronger rules against insider trading, or they will find an alternative investment vehicle. Either way, the capital market is less effective at its primary purpose of allocating capital.

My question for you, Don, is this: the above explanation is not original to me; I've read it numerous places, and I assume you have too. What, then, is your argument as to why efficient price discovery is more important than having capital markets that ordinary investors (non-insiders) are willing to trust with their investments?

I would argue that the real purpose of capital markets is to allocate capital, and in order to perform this function investors must be willing to put their capital in the market to be allocated.

How do you know how to allocate efficiently without knowing the price? Price discovery and allocation are inexorably linked.

Would be investors face all sorts of deficits - including education, skill and temperament. Professionals already exploit those deficits. Anyone with any information or skill advantage - whether it's insider or not - will exploit it. The insider trader gives up his information the minute his order hits the exchange. BTW, the volume usually shows up in the options. At that point the traders on the other side of the trade are aware that somebody has some opinion and they usually suspect that it's a "cheater" (an insider trader) and will trade with him. If they're smart.

BTW, despite the rules, insider trading happens more often than people think. Since the population is lulled into complacency, people get run over by it much more often than they otherwise would. Under the current rules, the capital markets are less efficient.

How do you know how to allocate efficiently without knowing the price? Price discovery and allocation are inexorably linked.

You do know the price; it's right there on the ticker. You're saying the price could be a little better, which may be true, but the cost is that the capital market becomes a crooked game in which investors are either insiders or suckers. In my opinion, that cost far outweighs the marginal benefits you could get from having slightly faster price discovery.

Would be investors face all sorts of deficits - including education, skill and temperament.

The average investor can overcome skill deficits through study or by hiring a money manager that has better skill. On the other hand, nothing an average investor can do will allow him to know that about a company's earnings surprise at the same time as that company's officers. Right now there are limits to how a company's officers can exploit that information advantage, and that keeps investors from getting fleeced by insiders.

At that point the traders on the other side of the trade are aware that somebody has some opinion and they usually suspect that it's a "cheater" (an insider trader) and will [not] trade with him.

So, some people are able to detect a whiff of insider trading and avoid it. Clearly there are plenty of people who can't, or nobody would never successfully trade on insider information.

BTW, despite the rules, insider trading happens more often than people think.

I don't doubt it, but the fact that a rule is imperfectly enforced does not by itself mean it should be scrapped.

Basically, Methinks, you're trying to argue that unrestricted use of non-public information would not result cause insiders to profit at the expense of outsiders. That's a very dubious claim. Theoretically there is every reason to expect that that is precisely what would happen, and empirically capital markets in jurisdictions without strong prohibitions against insider trading tend to be poorly capitalized and thinly traded. Neither of those are conclusive, of course. Theory can be wrong, and jurisdictions without insider trading rules may have other factors to recommend against them. However, in light of those observations, you'd have to work pretty hard to make a convincing argument that abandoning the prohibitions on insider trading would be a good idea.

Furthermore, even if insider trading is beneficial in fact, you still have a problem of perception to overcome. Investors invest in a market by choice, and if they perceive that a market that allows insider trading is rigged against them, then they will withdraw their investments and place them elsewhere, no matter whether the market really is rigged. In that sense, the burden of proof is on people who want to allow trading on non-public information to convince skittish investors that it is still safe for them to invest under the new rules, not vice versa.

Egad. This blog needs a preview function. Sorry for the typos and other errors.

Okay. Two comments I posted and two went into moderation. I don't know why, but I give up.

You really need to watch your language, Methinks.

The funny thing thing is that I didn't use any questionable language at all. For once. In fact, the moderation on this comment section is kind of bizarre. Totally innocuous posts just disappear into the black hole while bombastic posts sail through. After reading the Manne interview, I realize I said a lot of the same things in the lost posts, so it's no big loss.

It happens to me from time to time. Once all I posted were a set of links to health care research papers. Another time I just posted my unfiltered opinion of politicians... Well, it was probably right to pull that one.

How do you know how to allocate efficiently without knowing the price? Price discovery and allocation are inexorably linked.

If only outsiders traded, there would be plenty of price discovery. Even more if insiders are allowed, so it's a matter of degree not binary.

BTW, despite the rules, insider trading happens more often than people think. Since the population is lulled into complacency, people get run over by it much more often than they otherwise would.

I like that point.

I quite agree with your analysis. Let's say Don?

There's nothing morally wrong with insider trading all by itself. But insider trading legislation was the deal struck between people who wanted to raise capital (insiders with shallow pockets) and those who had capital (outsiders). Without the rule, outsiders wouldn't lend. It's the sort of rule you could imagine might spring up all on its own, and it might be better if it were enforced by some private institution, but it's not the end of the world that the government does it now. It's efficiency enhancing and both sides want it. Allowing insiders to trade would not improve market efficiency because there would be no market if not for the rule.

there would be no market if not for the rule.

Except that there was no insider trading rule before the 1960's and there clearly was a market!!!

The rule was in place in the USA before the 1960's according to Wikipedia, but not that much longer. I'm curious to know if there were less formal restrictions earlier - perhaps companies prohibited their employees from trading their own stock. In any case, I'll happily withdraw the strong hypothesis that markets wouldn't exist if insider trading were allowed and replace it with the weaker hypothesis that markets would be smaller and less developed. I'm not married to that position and I'm against most forms of regulation, but the weak form cannot be easily dismissed.

Gary, I see a 1966 court decision, but nothing about the rule before that. What am I missing in the wiki page?

Why would markets be smaller and less developed? I think you're assuming we have strong enforcement of the current rule. We don't. We really have hardly any enforcement at all because it's virtually impossible to enforce. So, the weak form is the strongest form you'll ever get. Professionals (who account for most of the market) know insiders trade every day and it doesn't bother them.

Securities and Exchange act of 1934, Section 10(b).

As for your second question, you've already noted that "Since the population is lulled into complacency, people get run over by [insider trading] much more often than they otherwise would." So some people are getting pummeled and then frightened away from capital markets when they realize they are too outside of the loop to trade competitively. Some people suspect that insiders will beat them and they never try investing. Our capital markets are pretty active and I don't want to come off as pessimistic about them, but we shouldn't underestimate how awesome capital markets could be if there were ever a chance to make them awesomer. Maybe enforced rules against insider trading would do that, maybe not. Milton Friedman was for insider trading, incidentally, and I'm probably on the losing end of Boudreaux and Friedman (and you). But I'm making the case...

Section 10-b is not an insider trading prohibition, Gary. Don't get confused by the SEC's later attempts to use the section in prosecuting insider trading cases. They were trying to establish insider trading as fraud and price manipulation - that is, they were trying to get a fraud conviction or strengthen the insider trading rule once it was adopted to set a precedent.

I said people get caught off guard. They don't understand the information that is being conveyed to them by changes in price and changes in trade size because they are convinced that the rule prevents people from trading on private information. Thus, they are slow to respond and THAT is what hurts them - not the insider trade itself. I never said they leave the capital markets. They don't - not permanently. If people leave permanently, they are in the extreme minority and they're probably leaving because they think they lack the skills to run their own portfolio. But, their money rarely leaves. They just leave the investing to someone else.

You're making the case for a semi-efficient market - a market where all public information is known and factored into the securities prices. I'm making the case (sort of) for strong-form efficient market - a market where all public and non-public information is factored into the securities price. In your words - a way awesomer market. But, in making the case, you've made me think about this issue. I usually don't. So, I'm glad you're making the case.

Don't get confused by the SEC's later attempts to use the section in prosecuting insider trading cases.

Conceded: the history of court cases in the early 1900s and then legislation later on doesn't look much like the industry lobbying for its own shackles.

Thus, they are slow to respond and THAT is what hurts them - not the insider trade itself.

Blame is immaterial to my point. If some number of people know they are not as fast and knowledgeable as insiders and expect to lose money because of it, there will be less money in capital markets as a result. That's got to be true at the margin.

The only way it's not true is if no investors suspect insider trading or no investors are afraid of it. Are you arguing one of those things?

Not sure what you mean by "making the case" in your last para. If I had to say whether current capital markets are closer to semi- or strong-form efficient, I would go with the latter.

If some number of people know they are not as fast and knowledgeable as insiders and expect to lose money because of it, there will be less money in capital markets as a result.

How will they lose money because of the insider trader? If you are long shares and bad news comes out, whether it comes out through an insider trade or through a press release, you will lose money. Remember, all the guy trading on material non-public information is doing is releasing the information. He's not creating the information. He is the messenger, not the message. The message is what changes the value of your stock.

You said you were making the case for a rule banning insider trading (that is - trading on material non-public information). I was responding to that.

Personally, I think we have some very efficient markets and some very inefficient markets. The market over-all is at best semi-efficient and I think that those inefficiencies are caused by a lot of stupid SEC rules that have nothing to do with insider trading. The Asian exchanges are learning from the SEC's mistakes, according to the regulatory circulars I'm reading from the Hang Seng and a few others. People do drop out of the U.S. market because of these inefficiencies all the time - yet the public is begging for more of those rules.

How will they lose money because of the insider trader?

Imagine you are one of ten shareholders in a company. The company has been a decade-long success, but its accountants discovered 10 minutes ago that the company will be bankrupt within a month.

Now consider two scenarios. In scenario A, the other nine shareholders are accountants with the firm. In scenario B, the other nine are your neighbours (outsiders). In scenario A, you will discover that the company is going bankrupt when the nine accountants sell all their shares, and you will be the last to try to mitigate your position. In scenario B, you will learn that the company is going bankrupt through a news release or because one or more of your neighbours sells all of their shares. In scenario B, you will have some non-zero chance of acting on the news first, some non-zero chance of acting second, etc. In scenario A, you have a zero chance of being anything but the tenth person to act. So it seems to be better to be a shareholder in a company with fewer insiders capable of trading.

The logic seems sound to me. But note that the logic doesn't actually have to be correct for insiders to be willing to restrict their trading in order to attract outsiders to the markets. It just has to be true that the common perception that insider trading can hurt your returns keeps enough people away from the markets causes insiders to do something about it. I don't know if that's true - I'm becoming more and more doubtful that the magnitude of the effect matters. But nobody has said anything to convince me that the effect doesn't exist.

Gary,

If you want to continue this, we should move it to email. methinks76@gmail.com

I am confused by your scenarios. I'm even more confused in how they answer the question. How exactly does the messenger make you lose money? Seems to me that even in all of your scenarios, the reason you will lose money is because the company is going bankrupt, not because insiders told you about the impending bankruptcy by trading on the information.

I'll play along. You're wrong - in scenario A, I am not at all guaranteed to be the last to act. I see an unusually large order appear in the stock (with ten shareholders AN order would be considered unusual, but whatever). I immediately think that somebody knows something. I watch to see if the order is done and the seller goes away. When he doesn't (and by "he" I don't care if it's one guy or a thousand - an unusually large order implies things), I join the order or better yet, step in front of him by a penny and get done ahead of him. I keep stepping in front of the other 9 insider shareholders so that I always get done first. So, it's very likely that I'll actually get out of my position before they get out of their's because I'm alerted by a change in trading behaviour in the stock. I will be almost garaunteed to blow out of my position at a better price than they. BTW, this behaviour in response to a suspected insider is the common response. Also, it's the response to any large order - hence the demand for dark pools. So, results of scenario A&B are pretty similar.

I can't prove a negative - that the effect doesn't exist. I think that companies may very well use a self-imposed prohibition on insider trading as a marketing tool for their shares if they think the public will perceive them better. There are fiduciary issues too. I have no objection to private companies imposing their own rules on employees and officers and rules restricting fiduciaries. But, we're talking strictly about a broadly imposed SEC ban here.

"Without the rule, outsiders wouldn't lend."

That isn't rational. They should be more likely to lend, because the price more accurately reflects the value of the investment.

Being able to buy in at a fair price is great, but investors might still be hesitant if they think they'll be the last to get their money out when things go badly. Surely you can see the rationality in that.

"investors might still be hesitant if they think they'll be the last to get their money out when things go badly"

If they loose money, why would they care whether or not people sold before they lost the money? That doesn't make any sense. You seem to think that investors care more about other investors than they care about their own finances. Maybe some do, but it is completely irrational. Especially in the case you cite, because the early traders alert the outsider SOONER to get his money out, because the price is affected sooner. The outsider only stands to gain by such an action, assuming he measures gain by his own absolute finances, and not his finances relative to others'.

If they loose money, why would they care whether or not people sold before they lost the money?

You've assumed they would lose the same amount either way.

Imagine a company with nine shareholders who are all accountants with the firm and... you. You might have been 5th or 6th to realize the company was about to tank if the other nine shareholders were outsiders like you. As it is, you'll probably be tenth. When selling falling shares, order matters.

Cite irrationality again. Maybe that will help.

I argued along these lines with my contracts professor who pointed to empirical evidence that insider trading raises the cost of capital because traders will be reluctant. My inclination is that low cost of capital is not the measure of capital markets, but couldn't articulate that on the fly. If we concede that costs of capital may go up when traders are less willing to participate, is the efficiency point weakened?

Lowering the cost of capital is one of the benefits of public markets. Aside from access to capital, it's practically the whole point.

However, I don't think insiders raise the cost of capital very much if at all because other traders will NOT be reluctant. The insider trade itself, when placed, gives the market information. As a trader, I merely trade on the information the trade gives me. I am not at all reluctant.

I find it difficult to believe that anyone could do a credible study that points to insider trading as a reason for increased cost of capital when the SEC has so many rules hampering liquidity - which raises the cost of capital.

First, I thought we were discussing equity markets and SEC. Confusing this debt markets, which provide access to capital, is egregious.

Second, as I mentioned above, the risk of no-trade equilibrium is real and amply discussed in the literature, both with theoretical models and empirical studies. Agree or disagree, but get informed, since it's information we are talking about.

"As a trader, I merely trade on the information the trade gives me. I am not at all reluctant."

I am saving this quotation. Good luck with your trades.

First, I thought we were discussing equity markets and SEC. Confusing this debt markets, which provide access to capital, is egregious.

uh, we ARE discussing equity markets. Are you not aware that equity markets provide access to capital? Are you also not aware of the CAPM model? Liquidity reduces the risk premium for equity financing, thus reducing the cost of capital. Capital can come in the form of debt and equity.

I don't need luck with my trades. I've been doing this too long and too successfully to rely on luck. But, thanks for the well wishes anyway.

Ahem, Brethren!

Raj Rajaratnam is arrested and charged with insider trading.

All members of Congress can do it with total impunity, and they are going to watch the farce played out on Mr. Rajaratnam.

What is worse is knowlegable people such as yourselves are going to watch it as well and never say a word about the sheer utter sickening hypocrisy.

God bless the Constitution and the corporation it founded, and God bless Congress the keepers of the corruption.

Read further, Vidyohs.

I brought it up and the fact that you brought it to my attention. The whole thing is farce - as are most SEC rules.

Methinks, trader != investor. I have nothing against traders, but companies need investors more.

And investors need traders because traders lower the transactions costs for investors when investors want to monetize their investments. The ability to quickly get in and out of investments via public markets lowers the cost of capital for the companies.

Good point, but there can be no traders without investors because without investors there would be no companies to trade. Don't say the words "chicken" or "egg" ;)

I don't watch TV, so I wouldn't know about the talking heads.

There's a spectrum from extremely short term traders to extremely long term traders. I'm sure you understood my loose use of 'traders' and 'investors' to reference that spectrum.

Financial markets could exist if it were a requirement that traders had to hold positions for 6 months, but they couldn't exist if traders willing to hold positions for 6 months didn't exist (or whatever numbers you want... you get the idea). Thus, it's probably more important to cater to the needs of those who might hold for longer time periods. But, really, I would be open to the legislators letting companies make their own rules about insider trading. I suspect harsh penalties against insider trading would pop up naturally, but am definitely willing to entertain the chance that they wouldn't.

BTW, I think you're conflating the investment needed for a non-public company and those required by public companies. Public companies don't require long-term investors.

I could be read to be making that conflation, but I'm not.

Long term investors help get prices right by thinking about the value of companies in the long run. Short term traders help get prices right, too, but only by predicting what long term investors will think. Without long term investors, there's no reason for the price to move toward something like the true value of the company. If long term investors disappeared from markets, I suspect the markets would disappear too. Short term investors would cease trading and prices would go to zero. I'm not sure about any of this, but that's my hunch.

You don't need long term investors for any of that.

All traders value the company by discounting the cash flow to today. Nothing else makes sense. Both a long term investor and a short term investor is investing today in today's dollars. Because everyone is trying to figure out fair value, and everyone is trying to sell above fair value and buy below fair value, the price converges to fair. The more liquid the stock, the faster that happens. No long term holding period required. Traders don't give two craps about what long-term investors think - they only care about the price at which they're transacting relative to fair value.

In fact, the opposite of what you believe is actually true. if a company has predominantly long-term holders, its price can be more out of whack because people don't sell when the stock is over-valued or buy more when the price tumbles. Those stocks are less liquid and suffer more pronounced deviations from fair value for longer periods of time and more price volatility because of it.

There are few long term holders of any public company's stock. As long as there is someone willing to buy or sell shares and the company doesn't go bankrupt, the shares have value and the stock price will reflect that.

Why on earth should something worth $50/share go to zero simply because there's not a guy willing to hold the stock for a year?

1. What about companies with no cash flow (biotech, internet startups, etc.) ?

2. Do you really believe that day traders are trying to figure out a company's fair value?

Wait a tick - aren't day traders the most outside you can get? They have the least amount of inside information. Therefore are day traders a good argument for insider trading and, if anything, a good argument AGAINST outsider trading?

To the extent day traders accomplish anything it is by short-term improvements in efficiency. I would expect insider trading to improve efficiency in the share prices, giving day traders less to feed on.

1.) A company doesn't have to have current cash flow to use the discounted cash flow model. If the cash flow is zero and expectations are for it to remain zero, then the stock has a valuation of zero. If cash flow is negative, the discounted value is less than zero and the company's clearly just a wealth incinerator. If the company has no current cash flow (or negative cash flow) but is expected to have positive cash flow in the future such that when all of those cash flows are discounted the NPV is positive, whatever that NPV is, that's the fair value of the stock.

2.) I believe that daytraders are just gambling dipshits. Sorry, but you asked. They have no idea what they're doing and they're vastly outnumbered by all the other market participant. Their cluelessness usually leads to a quick blow up and exit from the market, so I find little reason to consider them at all. My understanding is that they take on as much intraday leverage as they can get to take a position and then puke the position at the end of the day because nobody will let them hold that much leverage overnight. The hope is the position goes their way before they have to puke it. Once you start hoping and praying, you're no longer trading.

Good points.

All traders value the company by discounting the cash flow to today.

I believe there are trading strategies that are (relatively) unconcerned with fundamental valuation. Is that wrong?

Yes, that's wrong. The present value of the company's expected cash flow IS fundamental valuation. Can't get more fundamental than that.

Trading strategies are a different conversation entirely.

I didn't say anything contrary to the content in your first para. What are you talking about?

Traders don't give two craps about what long-term investors think - they only care about the price at which they're transacting relative to fair value.

There are traders who don't give two craps about fair value. Some of them make money.

Sorry, I misread your sentence.

Everyone gives a crap about fair value. How they arrive at fair value is what's different. Some people are really fond of squiggly lines drawings and call it "technical analysis" (you can tell I'm not), but it's all a way of saying that the security is above or below fair value. Fundamental analysis (Discounted Cash flow, etc.) is not the only way to calculate fair. And there are many many trading strategies too that take advantage of market inefficiencies and by doing so make the market more efficient.

BTW, some people can make money for a while by sheer dumb luck :)

but they couldn't exist if traders willing to hold positions for 6 months didn't exist

Why not?

Obviously they can and do. There are hundreds of financial markets in which literally every participant is out in less than 6 months. Less than a day, even.

It's not a chicken or egg question. "Traders" and "investors" are pretty much the same thing. I know that talking heads on TV give people the impression that they are somehow very different, but they're not really.

I guess the bigger difference is "market makers" and "investors" - and that's usually how I think about it. Market makers exist just to provide liquidity and make money on the spreads. But whether you're a "market maker", "trader" or "investor", you are still privy to all trading information and the insider information becomes public when the insider's trade is revealed on a public exchange and all are free to act on that information. So, I guess when I say "trader" I mean "one who trades". You must enter a trade to invest, so that includes investors.