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An Economic Defense Of Insider Trading

An Economic Defense of Insider Trading

By Jeffrey A. Miron

 February 12, 2012 -- One side effect of the 2008 financial crisis has been renewed attention to the ban on insider trading. This ban dates to 1934, when it was adopted in response to the Great Depression and the stock market crash of 1929; Congress and various Supreme Court decisions have strengthened the ban since.  In recent years the Securities and Exchange Commission has pursued several high-profile insider cases, such as that of Raj Rajaratnam, and Congress appears likely to ban “insider” trading by its own members.

Most policymakers, along with the general public, believe that insider trading should be banned. Yet straightforward economic reasoning suggests the opposite.
 
The most obvious effect of a ban is delaying the release of relevant information about the fortunes of publicly traded companies. This means slower adjustment of stock prices to relevant information, which inhibits rather than promotes market efficiency.

 Imagine, for example, that the CEO of a pharmaceutical company learns that a blockbuster drug causes previously unknown side effects. Absent a ban, the CEO might rush to sell or short his company’s stock. This would have a direct effect on the share price, and it would signal investors that something is amiss. Insider trading thus encourages the market to bid down the shares of this company, which is the efficient outcome if the company’s fortunes have declined.
 
Under a ban on insider trading, however, the CEO refrains from dumping the stock. Market participants hold the stock at its existing price, believing this is a good investment. That prevents these funds from being invested in more promising activities. Thus the ban on insider trading leads to a less efficient allocation of the economy’s capital.
 
Whether these efficiency costs are large is an empirical question. Short delays of relevant information are not a big deal, and the information often leaks despite out the rules. Thus, the damage caused by bans is probably modest. But efficiency nevertheless argues against a ban on insider trading, not in favor.
 
Policy should want small investors to believe they are at a disadvantage relative to insiders.
And bans have other negatives. Under a ban, some insiders break the law and trade on inside information anyway, whether by tipping off family and friends, trading related stocks, or using hidden assets and offshore accounts. Thus, bans reward dishonest insiders who break the law and  put law-abiding insiders at a competitive disadvantage.
 
Bans implicitly support the view that individuals should buy and sell individual stocks. In fact, virtually everyone should just buy index funds, since picking winners and losers mainly eats commissions, adds volatility, and rarely improves the average, risk-adjusted return.
 
Thus, if policy is worried about small investors, it should want them to believe they are at a disadvantage relative to insiders, since this might convince them to buy and hold the market. Bans instead encourage people to engage in stupid behavior by creating the appearance – but not the reality – that everyone has access to the same information.
 
The ban on insider trading also makes it harder for the market to learn about incompetence or malfeasance by management. Without a ban, honest insiders, and dishonest insiders who want to make a profit, can sell or short a company’s stock as soon bad acts occur. Under a ban, however, these insiders cannot do so legally, so information stays hidden longer.
 
Thus, bans on insider trading have little justification. They attempt to create a level playing field in the stock market, but they do so badly while inhibiting economic efficiency.


Related Reading: "The Morality of Insider Trading"
 

Jeffrey A. Miron is Senior Lecturer and Director of Undergraduate Studies in the Department of Economics at Harvard University and Senior Fellow at the Cato Institute. Miron is the author of Libertarianism, from A to Z.

 

 

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