Professor Donald J. Boudreaux at George Mason University recently wrote an article arguing for the relaxation of insider trading rules for the Wall Street Journal. For decades, the practice of Insider Trading has been condemned and heavily punished by small investors and prosecutors alike, but are the negative stigma associated Insider Trading economically justified? Or has society been handing out jail sentences to people who made the capital markets more efficient?

Insider Trading – A Brief History

So what is insider trading? Although the complete definition is far more convoluted than I have room to explain, Insider Trading consist of trading the securities (stock, bonds options etc.) of a public company with non-public information. For example, if a friend of mine who works at Microsoft told me that Windows 7 contains a major bug that will cost the company hundreds of millions of dollar, and I subsequently short Microsoft’s stocks Before that information becomes apparent to the general public, then I would’ve committed insider trading.

Possession of such information creates an unfair advantages in the marketplace, as a result U.S. legislators and regulators have erected legal barriers to prevent insiders from trading and swiftly penalized those violated the rules. Major insider trading busts have consistently captured media spotlights with cases like Martha Stewart in 2003, and more recently,with the indictment of Galleon hedge fund founder Raj Rajaratnam.

Boudreaux’s Main Arguments

Professor Boudreaux strongly argued that prosecuting Insider Trading is a big waste of time and resources, his reasons are summarized below:

1. Insider Trading helps the market function more efficiently because it allows stock and bond prices to adjust faster to the economic reality of the underlying company.The price of a company’s stock reflects investor’s expectations about the company’s future performances and the uncertainties associated with those expectations (Thank you FIN 300). But keep in mind that those expectations are driven by Information about the company. So in that sense, the more information we have regarding a firm, the more accurately we can predict their future cashflow. But as law-abiding investors, we only have access to a company’s financial statements, press releases, rumors and our own opinions, all of which are information from the past. The people with the most reliable information about what is currently going on in a company are the insiders. If these people are allowed to make trades of sufficient volumne based on these private information, then both the fact that they are trading and the resulting  price movement from their trades are essentially sending a signal to the rest of the market about What is Really On with the company. The equilibrium price after the insiders have made their trades would be a more accurate representation of the firms value than if the insiders weren’t allowed to make those trades.

   (Imagine if Enron employees gradually started selling Enron stocks in the year before the scandal surfaced, the market would’ve sensed that something is going wrong and avoided the nasty surprise).

2. We only prosecute people who make Trades with insider information, but there are just as many people who decide that they aren’t going to trade after obtaining insider information (aka. Insider Non-trading). The presence of non-traders hasn’t negatively affected the markets, so why should the insider who does trade?The occurrences of insider non-trading is undetectable. Lets say I was planning to buy Nike’s stocks, but then decided not to after receiving news from an employee that several managers have pissed off some partners and are expecting to face billion dollar law-suits next year. Technically, I’ve just committed insider trading (I used insider information to aid in my decision making) but since I didn’t make a trade, nobody will ever find out about it (even if they do, its kinda hard to accuse someone of Not buying a stock). But look at what just happened? Having insider information not only helped me avert a personal tragedy, but also prevented the stock from being even more overvalued.
3. Allowing firms to decide which information should or shouldn’t be used for trading will help these firms obtain a lower cost of capital
   
   Not all Insider Trading activity help make the market become more efficient though. Certain information, especially regarding Mergers & Acquisitions, Need to be withheld. Boudreaux’s most brilliant argument states that rather than classifying all Insider Information as taboo for trading purposes, firms should choose which information must remain proprietary and which information counts as fair game. The government can’t possibility know which Insider Information will hurt or help market efficiency for every business in the country, so the best solution is to let management to customize their policy. Ideally, managers will then permit insider trading to the extend that it optimize the firms productivity, which reduces public investors’ perception of risk associated with the firm’s performance estimates, and thus lowering the required rate of return on the company’s stocks and bonds. As a result, companies will then have a easier time raising capital and investors will know exactly where to put their money.

Time for Reform?

On a personal note, although I firmly believe in all the arguments presented above, reforms to the current regulations (if there is to be any) should be taken with caution. The liberalization of insider trading could trigger conflict of interest (which is probably why the rules were there in the first place). For example, an employee could decide to take a huge short position his or her own company stock, and then use his or her influence in the company to negatively affect performances.

Also, there are enforcement issues associated with letting firms draw the line on which information can be used to make trades. Imagine a company that prohibits insider trading on M&A information, the CFO can sell his stake in his own company and buy the shares of a company that he intend to acquire, and then initiate a take-over bid several month in the future. Technically, he just used his power to influence M&A activity in his trades, but how can someone prove those were his private thoughts? He could argue that the idea of the merger came into his mind way after he has made his trades on some legal information.

The economic benefits of allowing certain insider information to influence trades is probably very real and substantial, the improved transparency and lower-cost-of-capital will help channel funds to where they are needed the most, which in turn could mean higher long-term GDP. however we as a society must address the legal loopholes that will be created with the relaxation of these regulations, before we move hastily to remove them.