Founded in 2016, Ceteris Paribus is A student-led economics and finance publication at Davidson College.

Should Insider Trading Be Illegal?

by Shiv Palit

 

Raj Rajaratnam, a former hedge fund manager, being arrested for insider trading in October 2009. (Image via Reuters)

Raj Rajaratnam, a former hedge fund manager, being arrested for insider trading in October 2009. (Image via Reuters)

Contrary to popular belief, not all forms of insider trading are illegal. Investors may buy and sell securities of the firm that employs them with the use of inside information as long as they register these transactions with the SEC. The illegal form of insider trading comes from the use of undisclosed information that could affect a company’s stock price, or “material” information, for a profit. Virtually anyone can be considered an illegal insider trader, not just those involved with the company, as long as they make transaction decisions based on undisclosed material information.

Since 1934, when insider trading became illegal in the United States, economists have argued the merits of its restrictions, and whether or not they improve market efficiency. However, regulators like the SEC have only started enforcing insider trading laws with vigor in the past 30 years. But why is insider trading such a bad thing? And does it really improve market efficiency?

According to the SEC, insider trading “undermines investor confidence in the fairness and integrity of the securities markets.” Insider traders are considered to have an unfair advantage in the market since they have the power to “artificially influence the value of a company’s stock.” Therefore, the SEC views many cases of insider trading as securities fraud, and could convict insider traders of larceny or theft.

Many believe that insider trading laws benefit the market and improves efficiency. However, there is evidence to suggest that such laws in fact reduce market efficiency. Insider trading laws create a distinction between “public” and “non-public” information, and only allows trade to occur based on public information. By prohibiting non-public information from being used to make securities transactions, the SEC prevents the market from reflecting all available information. This inhibits investors from acting on, and markets from reacting to the latest and most accurate information, thus causing market inefficiencies.

Furthermore, it can be argued that insider trading laws actually create artificial market prices rather than prevent them as investors are under the false impression of the market reflecting all available information. Therefore, the prices reflected in the current market could be considered “artificial” as such, since the information used to trade securities and determine prices can be considered controlled or regulated.

Due to insider trading laws, investors are expected to make today’s trades based on yesterday’s information. Not only do insider trading laws arguably prevent “real” market efficiency, they are inefficient in preventing all forms of insider trading itself. The laws and restrictions only account for insider trading that results in the buying or selling of securities. However, it does not account for insider decisions to not buy or sell securities, which often leads to an outcome equally as significant.

If insider trading were tolerable, it would serve as an efficient means of communicating market information. Since security prices reflect all publicly available information, but not the non-public information, transactions made by insiders will reveal the private information component to the market. Even if the insider is anonymous, an increase or decrease in the demand for a particular stock will be reflected in the market, and prices will move accordingly. This would result in prices moving towards the “correct direction”, since the insider transactions will reflect the latest, and most valid information of the securities being traded.

One of the primary functions of the market is to accurately represent prices. Therefore, to exclude non-public material information is counterintuitive. Some argue that insider trading erodes public confidence in markets. However, I believe this argument to be invalid. In fact, insider trading would arguably increase confidence since investors will be certain that prices are up to date, and accurately reflect all public and non-public information, thus preventing unexpected shocks due to unknown information. We must stop treating insider trading as a crime, and realize its advantages in promoting highest levels of market efficiency.

The concern, however, still remains that it is unfair to public investors who do not have access to non-public material information, and are therefore at a disadvantage to those who do. I would argue that such a disadvantage is less cause for concern than inefficient markets. At least with a handful of participants in the market acting on insider information, the market is still able to reflect accurate information and prices. And even though outside investors will not be able to profit at the same level as insiders, they will be able to analyze market activity more with higher levels of certainty, allowing them to make investments with more confidence and lower risk.

 

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