Intervention for your own good

Insider trading feels unfair, but increases the efficiency of financial markets. A price should reflect an estimate of the future profitability of the underlying asset, and insider trading allows those with the most information to have more of an impact on that price.

The Supreme Court is currently considering a case that will determine how broadly to define insider trading. If the defendant loses, then cases where a family member of an insider benefits from a stock tip could be considered insider trading. If he wins, it will probably be much more difficult to prevent insider trading. But why should we?

Some argue that the possibility of insider trading creates a problem of asymmetric practicable information–insiders always know more, but if they’re allowed to act on that information, outside investors lose incentive to invest in potentially valuable projects. That may be, but does it justify prohibiting insider trading? No.

The problem of asymmetric information requires a commitment device, but that device doesn’t have to be one-size fits all. Let businesses and investors solve this problem themselves with contracts.

Feds File Charges Against SAC Capital

Thanks to Dr Gibson for alerting me to this. He’s also got a piece on insider trading that was first published in the Freeman in December of 2010. We’ve been able to reproduce it here at NOL. He writes:

Insider trading is restricted but not entirely forbidden. Just what constitutes the “bad” kind of insider trading? This is generally understood to be trading on information originating within a company that could have a material effect on the share price had it been publicly known. The law applies not only to insiders—employees and directors—but also to any outsiders to whom inside information is disclosed […]

We see that insider-trading regulations are subjective and arbitrary, rivaling antitrust laws in this respect. It is no wonder that Congress never defined insider trading and that the SEC resisted defining it for many years; the courts have had to make up the rules as cases arose. Every so often someone like Martha Stewart is thrown to the lions, drawing cheers from the jealous and spreading fear to successful and therefore high-profile managers.

Dr Gibson’s suggestions for alternatives to government regulation are, by themselves, worth the price of admission.

Update: this piece, also by Dr Gibson, explaining what hedge funds are is well worth your time, too.