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Here’s a thoughtful piece on the merits and demerits of criminalizing insider trading [2].
Among the most common arguments made today in favor of the criminalization of insider trading (as opposed to letting corporations, in competition for capital, decide which information is and isn’t appropriate for insiders to trade on) is expressed in these paragraphs of the article linked to above:
“I think there are some libertarians who think we should allow it,” says Wharton finance professor Jeremy J. Siegel. “But I think insider trading is not a good thing. It makes it more risky to buy securities. When someone is offering to buy or sell, it might be that he or she has some inside information and you are going to get duped. So you cannot trust that you are going to get a fair price.” Put simply, insider trading means other investors pay more than they should when they buy and get less than they should when they sell.
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[I]t’s important to prosecute insider trading cases because the practice can hurt individual investors and undermine the public confidence that allows firms to raise money in the capital markets, says Eric W. Orts, professor of legal studies and business ethics at Wharton. “The danger is you lose a broad public faith in the markets, and people take their money out.”
I’ve never understood why so many people find this “confidence in markets” argument to be compelling.
If insider trading (on non-proprietary information) causes asset prices to reflect more accurately the true, long-run values of those assets, then insider trading should increase confidence in markets.
Put differently, ordinary investors would be less confident in markets that take an average of t units of time to incorporate into asset prices a piece of relevant information than these investors would be in markets that take an average of t+1 units of time to achieve the same adjustments to asset prices.
To the extent that insider trading causes prices to reflect asset values more quickly and more accurately, general investors should be more confident in asset markets and, hence, more likely to invest their earnings in such markets.
When Jeremy Siegel says that, with insider trading, “you cannot trust that you [a non-inside investor] are going to get a fair price” — I immediately ask: why not? Precisely because insider trading brings asset prices into closer alignment with their ‘true’ values more quickly than would be the case without insider trading, on average the prices at which investors buy and sell assets will be more ‘fair’ — i.e., more truthful — with insider trading than without insider trading.
Suppose, for example, that shares of Acme Inc. are now selling for $50 per. Suppose also that an insider knows that Acme’s CEO and CFO have been cooking Acme’s books to make Acme appear to the public to be more profitable than it really is. If that insider can trade on that non-public information — obviously, by shorting Acme stock — the price of Acme stock will start to fall immediately upon the commencement of such insider trading.
Any trader who buys Acme stock after this insider trading commences gets a ‘fairer’ price — a more truthful price — than that trader would have gotten if Acme’s shares were still trading at $50 due to the fact that information about Acme’s true financial state remained private and unincorporated into Acme’s share price.