The Aresan Clan is published four times a week (Tue, Wed, Fri, Sun). You can see what's been written so far collected here. All posts will be posted under the Aresan Clan label. For summaries of the events so far, visit here. See my previous serial Vampire Wares collected here.

Wednesday, May 18, 2011

Insider Trading

If you're like most people, you probably assume that insider trading is unambiguously bad. You've seen Wall Street and see Gordon Gecko as the villain and probably couldn't imagine that anyone would support insider trading. You'd be surprised that among economists the virtues of insider trading are rather controversial. There's a thorough summary of the debate and the literature on the topic here. Considerable empirical research has gone into the question of the effect of insider trading, without any clear consensus. Many economists think we should drop insider trading laws and some think we shouldn't.

Attempts to answer the question through empirical research have proven difficult because we have only a limited grasp of the extent of insider trading. There is no doubt that the few persons convicted of insider trading, like Martha Stewart and Raj Rajaratnam, represent a small sliver of the overall practice. Discovering whether someone had special insider knowledge motivating a trade is especially hard in the best of circumstances, and it's even harder to discover when special insider knowledge leads a person not to make a transaction (for example, if someone was thinking of buying or selling, but got wind of some info which led them to decide against it).

One plausible problem of insider trading is that it shifts resources from outsiders to insiders. This would only happen in cases when securities, such as stock, are increasing in price, but the idea is that the insiders can use their earlier access to knowledge to buy greater amout of stocks at a lower price, before the rise. The rejoinder to this is that insider trading could permit companies to lower the salaries of management. Because the information they have access to will be more valuable in the absence of insider trading laws, direct compensation (salary and benefits) can be reduced and the benefits of this pay cut passed on to shareholders.

The main argument for why insider trading is advantageous is that, as a market, any securities market, like the stock exchange, serves as the consensus among investors of the real value of a company's stock. It's a crucial source of revenue for a company, so underpricing can disadvantage a worthy company just as overpricing can unfairly benefit an unworthy company. The market seeks out the correct price through the price changes caused by investors' buying and selling. But, since investors are always facing imperfect knowledge, price will be an imperfect measure of value. The more knowledge those investors have, the better they'll be able to set the price. Insider trading will thus make the price of shares more inaccurate. The case often cited is that of Enron, which in 2001 had become grossly overpriced, and crashed in price as soon as it was revealed that the company's accounting practices had masked their profound financial unsustainability. Insider trading would've brought Enron down to reality much quicker, would've forced them to bankruptcy much sooner, saved many shareholders (those who invested in the company late in the game and lost their shirts) lots of money, and would've benefited the economy by transferring its resources into the hands of other companies that could put them to more productive use.

From a moral perspective, the counter arguments are that insider trading is fraud and it's unfair. The idea that it's fraud derives from the earliest supreme court decision on insider trading, before there was even a law on the books against insider trading. The 1909 supreme court, in Strong V. Repide decided that when a person has access to insider information, doesn't make it public, and then transacts based on that insider information, that person is committing fraud. This argument relies upon a supposed duty to make this information public. In other words, since I must make such information public, then the practice of not making it public is a deliberate withholding of information, which is a form of deceit. But without this duty to disclose, then the case for deliberate deceit doesn't hold. Certainly, there might be cases, where such a duty makes sense, such as if you told someone some information, and then failed to apprise them of a change in circumstances, or if a person specifically requested information and you withheld it. But it's hard to make the case that all instances of withholding information represent fraud. Additionally, there are clear cases, such as if a person is not in a position to make public insider information (for example, if a person is contractually prevented from disclosing certain information) or if a person is responding to non-verifiable information (for example, if a person hearing rumors, which can't be verified), which it might be risky to reveal, especially if the information turned out to be untrue. In short, it seems unlikely that insider trading necessarily involves fraud, and if there is fraud in particular cases, then relevant law should apply to that fraud.

The other, probably more common, argument is that insider trading is unfair. The idea is that since the insider has unequal access to certain information, using that information to their advantage is unfair for everyone else who doesn't have access to the information. This is undoubtedly true, but such unfairness is also a common feature of life. I use my superior knowledge of philosophy to secure positions teaching philosophy to people less knowledgeable. Real estate agents use their superior knowledge of the real estate market to make themselves useful to potential buyers and sellers. People negotiating transactions in many instances frequently try to control information to make for the best deal.

Additionally, it's also worth it to ask : to whom is it unfair? As Robert Murphy explains:

For example, suppose a Wall Street trader is at the bar and overhears an executive on his cell phone discussing some good news for the Acme Corporation. The trader then rushes to buy 1,000 shares of the stock, which is currently selling for $10. When the news becomes public, the stock jumps to $15, and the trader closes out his position for a handsome gain of $5,000. Who is the supposed victim in all of this? From whom was this $5,000 profit taken?

The $5,000 wasn't taken from the people who sold the shares to the trader. They were trying to sell anyway, and would have sold it to somebody else had the trader not entered the market. In fact, by snatching the 1,000 shares at the current price of $10, the trader's demand may have held the price higher than it otherwise would have been. In other words, had the trader not entered the market, the people trying to sell 1,000 shares may have had to settle for, say, $9.75 per share rather than the $10.00 they actually received. So we see that the people dumping their stock either were not hurt or actually benefited from the action of the trader.
In fact, the only people who demonstrably lost out were those who were trying to buy shares of the stock just when the trader did so, before the news became public. By entering the market and acquiring 1,000 shares (temporarily), the trader either reduced the number of Acme shares other potential buyers acquired, or he forced them to pay a higher price than they otherwise would have. When the news then hit and the share prices jumped, this meant that this select group (who also acquired new shares of Acme in the short interval in question) made less total profit than they otherwise would have.

In short, in any particular instance of insider trading there will be winners and losers. Some people may actually benefit from another person's insider trading, just as I gave the example of people who bought Enron stocks in 2001 just before it tanked and lost huge amounts of money (if the company's stock had fallen earlier, these people would've benefited). The people who benefit or lose do so by complete accident; there's no fairness to the distribution of benefits and losses in these cases; it's just how it happened.

Additionally, it's also frequently assumed that insider trading is some sort of guarantee. But the reality is that there is still risk involved. The insider information might affect stock prices in surprising ways, not to mention that the insider information may simply turn out to be false.

Thus, though we can't deny that there is a certain unfairness to insider trading, these considerations should mitigate that unfairness, and considering that a market will perform better with better information, it seems that overall insider trading is beneficial. In Wall Street Gordon Gecko had told Bud Fox that the stock market is a zero-sum game, but this is completely inaccurate. The stock market has grown in size considerably since 1987 when the movie was released. A healthy functioning market will in fact be a positive-sum game, and will perform all the better with better information, generally benefiting those who participate in it. There undoubtedly will be winners and losers and inevitable unfairness, but overall insider trading is a net benefit.

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