Should Insider Trading Be Legalized?

Until recently, I did not know who Doug DeCinces was. Apparently, he is a former B-list Major League Baseball third baseman. As of a few weeks ago, he was found guilty on 14 charges of insider trading. Instead of going down in the history books as a mediocre baseball player, he will be known as a crook and fraudster. This got me thinking a little more. DeCinces is hardly the first person convicted of insider trading. Martha Stewart and Enron are the two most famous cases of insider trading out there. When we see insider trading on the news or in movies, we think about white-collar crime, but it is portrayed as high up on the list of white-collar crimes because the information used in insider trading can hurt others in the process while those privy to the information make lots of money. But what exactly is insider trading?

Insider trading entails the trading of a public company's stock by individuals who possess nonpublic  and material information about the company. What comes of as egregious about having this information is not that its nonpublic nature (since trades are reported to the Security Exchanges Commission), but rather that it's material. In this case, "material" is defined as causing a substantial change in price if that information were made public. What the inside trader does is "act on private information that more accurately reflects the future value of some financial asset than the current price does." Should the law punish someone who is privy to certain information before others are?

Much like any argument, there are at least two sides to it. For insider trading, the main argument against insider trading is that it gives undue advantage to the person possessing the nonpublic and material information. It can be seen as exploitable. Between a low opinion of Big Business, the Great Recession, and income inequality being a hot-button topic in today's political climate, do we really need to give the "1 percent" a greater advantage than they already have? Legalizing insider trading could create greater animosity towards Wall Street and the "1 percent," as well as erode confidence in financial markets.

One counterargument is that a quarter of public company deals involve some sort of insider trading (Augustin et al., 2014). Insider trading is already commonplace, even with SEC regulations. From someone who has worked in market research, there is going to be some form of information asymmetry, regardless of SEC laws. Being able to provide a "level playing field" is impossible. Even if all the information were available, some individuals and entities will be more diligent in their research than others. One party will always have superior information to another.

Insider trading regulations stifle the flow of information. This is significant since one of the functions of price is to transmit information. In the case of stocks, the prices embody what traders expect in the future. Take the Enron scandal as an example. If the market were freer in that scenario, people would have been selling Enron stock at a quicker rate. The dissemination of the price drop would have signaled something was up (i.e., they were cooking their books). Distorting prices means that prices are misplaced, and stocks are thus miscalled. The Federal Reserve Bank of Atlanta conceded back in 1997 that such distortion exists.

Even if that information were more readily available, the stock market deals with fickleness, and often times brings fortune based on sheer luck. To make it more complicated, only two out of twelve types of scenarios are even prosecutable (see below), and as the Wharton School of Business points out, even identifying those cases are difficult. Those who function in the stock market know that the stock market is a high-risk endeavor, but also participate in it because there are also high rewards. All of this would explain why there really is not a victim of insider trading (see arguments here and here).

Another interesting argument for legalizing insider trading is that if it were that bad, corporations would prohibit insider trading from happening. Why? Because disclosure of "inside information" can affect the bottom line of executives. Companies can use contracts in common law to prevent it. If companies have not found it damaging, why should the government get involved?

The case for insider trading is not clear cut and dry because there are some arguments that could help the case against insider trading, such as harming specialists who charge a "bid-ask" spread, not deterring various types of investors to participate in order to hold together the modern securities market, and the conceivability of capital fleeing the market (that latter one seems tenuous given how much insider trading exists even with insider trading regulations). For those crying foul on insider trading, what I would like to see is better empirical evidence that a lack of insider trading laws causes harm. For instance, a study from Duke University (Bhattacharya and Daouk, 2002) showed that insider trade laws reduces the equity of a law by 5 percent, while a study from the Brookings Institution finds that insider trading increases market volatility (Du and Shang-Jin, 2002).  There are arguments for insider trading (e.g., Smith and Block, 2015) and against insider trading (e.g., Bainbridge, 2001). At the end of the day, I would like to see more empirical evidence on the adverse effects of insider trading before I even begin to consider siding with the SEC. Otherwise, I am going to speculate that legalizing insider trading is better than putting onerous regulations on it.