Who Loses from Insider Trading?

Read it and still don’t buy it, just as I didn’t buy it last time it was posted. My true opinion would be moderated for rudeness and language. It’s like saying someone stealing small amounts from the poker pot doesn’t harm anyone as the true winner was not deserving either.

I am generally sympathetic to Charles Hooper’s position, however he seems to be only looking at this from the perspective of trading. Isn’t there a potential agency cost issue here?

The law of agency developed to try to prevent agents from deriving benefits from the P-A relationship outside of the agreed upon price P pays A to be P’s agent, precisely because of the agency problem — there is a fear A will act in A’s interest at the expense of P.

Legalizing insider trading may encourage abuses by corporation’s agents, as they attempt to create situations wherein they can benefit from insider knowledge. Of course, corporations themselves can attempt to solve this by passing binding prohibition of insiders trading in their corporation’s stock, but that would likely have to happen at the SH level, which faces a collective action problem. Further, there are a lot of ways insiders could sub-optimally steer a corporation in order to get insider returns that are unrelated to stock in the corporation per se.

Corporate law would not be a good salve to this problem, as the BJR (rightfully) is deferential towards the Board and Management.

So, perhaps insider trading harms corporate values by encouraging managers to pursue their own interests at the expense of SHs. In this way, Insider Trading isn’t really about criminal law, but instead is (an albeit clumsy) solution to this difficult agency problem.

Prof. Henderson,

Clever solution to the potential problem I highlighted. Basically, allow an opt-in instead of an opt-out.

@Zeke,
Clever solution to the potential problem I highlighted. Basically, allow an opt-in instead of an opt-out.
Exactly, and thanks.
I think one could argue that the threshold should be lower than 50%, precisely because of the collective action problem. Possibly 40%?

@Jeff,
Can you honestly say that you read the whole article?

@David,

I had not read the whole article before commenting because I’ve seen this argument before. But after seeing your comment, I have now read it all, and my opinion is unchanged. This is an old argument, and it still fails.

The Uninformed Buyer may or may not be “deserving”, but as Will Munny (Clint Eastwood’s character in Unforgiven) said, “Deserve’s got nothin’ to do with it.” Who “deserves” to win a poker hand? No one. But not many people are going to play in a poker game they know is rigged against them. If you want to have a long-running game with a lot of participation, you’re going to have to run an honest game.

Insiders may or may not make the market more efficient. It’s true that their trades do reveal some information sooner than it otherwise would be revealed, but how much information discovery by non-insider traders is discouraged when insider trading is allowed? Why work hard to uncover fundamentals and try to figure out which stocks are undervalued when the inside traders are going to steal some of the profits you might have made by doing so?

Why do you think that buy and hold investors are unaffected? I buy index funds for my 401K, and that’s about as buy-and-hold as you can get. If total market returns are not affected by insider trades, then the profits they make have to be coming at the expense of the overall market. As an index fund holder, that’s me.

Lots of murders go unsolved. I don’t think that means we shouldn’t prosecute the killers that are caught, do you?

investors who lose when insiders trade are even less deserving of the windfall profits than the insiders themselves.

I consider that someone who buys a lottery ticket deserves the win if they get it, and a shop keeper who hoodwinks someone into selling the winning ticket for a pittance is acting unethically.

And once insider trading is completely acceptable, I would assume that the market would provide appropriate financing to assure that insiders would reap almost all windfall profits.

It would also make corporate governance interesting, where there’d be strong personal motivation to engage in transactions that provide massive changes in stock prices that insiders could take advantage of.

Of course, I could be wrong. Are there any examples of successful stock markets where insider trading is utterly unrestricted and enough time has passed to create the financial mechanisms to take advantage of this?

I am not going to comment on the economics of insider trading, but I will take issue with the author reaching his conclusions from a case that does not address those points. This is not a case about trading by an insider. It is a case about someone who came to hold inside information, shared that information without revealing it was inside information, and did not benefit from the disclosure. No one here traded on inside information, hence the acquittal. This is not new law, nor anything novel. The issues were settled in Dirks v. SEC, 463 U.S. 646 (1983).

Here’s a critically important quote from the case: “Newman and Chiasson [the defendants] were several steps removed from the corporate insiders and there was no evidence that either was aware of the source of the inside information.”

Jeff is right. This is a standard result in economics. Information asymmetry will result in lower liquidity, larger premiums, and in extreme, complete market failure.

How large the effect depends on the degree of the asymmetry, number of repeated interactions, prevalence of insider trading, etc.

It’s an empirical question (a very difficult empirical question to quantify), and in no way is there a consensus that the effect on the markets is small.

See for instance:

https://faculty.fuqua.duke.edu/~charvey/Teaching/BA453_2005/BD_The_world.pdf

@Tom West,

Your lottery ticket example isn’t appropriate. Once the purchase has been made, of course, the owner deserves the payout. And no one is doing any hoodwinking.

A more appropriate example would be where the original lottery ticket purchaser decides, at the last minute, not to purchase the lottery ticket and then feels cheated by missing out on the jackpot. Yeah, we would all feel bad in that situation. But we didn’t buy the ticket!

A more appropriate example would be where the original lottery ticket purchaser decides, at the last minute, not to purchase the lottery ticket and then feels cheated by missing out on the jackpot.

It’s not a perfect analogy, but I did buy a ticket. There was no way of knowing that the winning numbers had been selected. That I chose to sell it to on the basis of information that I could not legally obtain would make me feel ripped off.

This may be one of those Libertarian things where the policy works for Homo Econimus, but not for human beings (sort of like taking windfall profits in a crisis – we may be better off on paper, but it doesn’t matter if it makes everyone miserable).

@Tom West,

I’m confused. Why would you purchase a lottery ticket and then sell it before the winning numbers were selected?

Dan,

It is possible, and even likely, to agree with your entire statement and yet still believe that insider trading prohibitions are useless at best and presumably harmful. Such prohibitions do not reduce information asymmetry and in fact increase it, particularly considering that prices themselves are the most democratic form of information. When insiders price things correctly, the overall asymmetry is reduced.

Tom West and Rick Hull,

You can’t win the lottery unless you buy a ticket. If you decide against buying a ticket or choose to sell your ticket before the results are announced, you can’t win. You had the choice. No one cheated you.

You had the choice. No one cheated you.

To me, “cheating” is predicated on presumption of the “rules” and thus will be defined differently by different people. It’s why I use ‘feel cheated’ as opposed to ‘being cheated’.

After all, I’m certain there’s a whole (and historically large) class of people who would sneer at the idea that I would consider it cheating to relieve me of my lottery ticket at gunpoint. After all, what sort of idiot ignores the most basic form of human interaction? :-). If I chose to buy something and then *chose* not to protect it adequately, it’s my fault.

It’s all about assumptions of what constitutes fair.

Anyway, your data point about HK is interesting and an indication that markets don’t instantly fall apart when insider trading is unregulated.

I looked but I couldn’t find any studies indicating whether this influenced the percentage of gains that went to insiders in HK.

Still, for me, the psychology is strong. I wouldn’t invest in a market where it’s considered legal and ethical for insiders to take advantage of their investor’s ignorance. Just as I would never knowingly do business with (or be part of) such a company.

However, I may well be in a small minority, as HK’s stock market is still going strong.

Some points are missed by some commentors:

1. The purpose of a stock market is not to function as a game of chance. It is to redirect capital to better uses. Uninformed buyer and uninformed seller are not lottety players, they are directors of capital. The effect of insiders is to improve the price mechanism for such direction. This benefits, rather than deters, users of capital.

2. If there is any offense against UB or US, it is in whatever human action makes them err about price. Such action comes not from the insider, but only from the companies (who have the property rights) or the government regulators (who do not). The insider cannot be an offender.

3. The insider is still making a prediction. He could be wrong about the market response, in which case he loses part of what he spent on the shares–a kind of loss never experienced by the UB or the US. The insider is still taking a risk. Not a lottery ticket type of risk, but a risk based upon specialized knowledge.

4. To whatever extent insider trading truly provides returns to the insiders, a regime in which it is permitted would offset other forms of employee compensation. So, the zero sum game argument that insider trading must come at the expense of losers, is weakened.

Am I missing something, or is the underlying economic theory not extremely obvious here? Of course more insider trading leads to wider bid-ask spreads as traders expect more adverse selection against their betting. The more you expect other market participants know something you don’t know and that hasn’t been priced into the settled price (as it would be priced in if there were both informed sellers and informed buyers striking a market price) the greater the risk premium you should demand for agreeing to buy, or alternatively sell, after you condition on the other person being willing to sell or buy.

This seems extremely clear theoretically, and it would take pretty strong empirical evidence before I stopped believing this was how markets worked. If bid-ask spreads on modern markets don’t visibly widen when the risk of insider trading grows, that could be because trading professionals are being paid to assume this risk. Then when inside trading increases, the amount the professionals get paid by retail investors to assume this risk increases, the professionals’ loss to insiders increases, insider profit increases, and retail investors’ profit decreases, which decreases average return on investment available to that class of investors, which decreases investment, etcetera.

Am I missing something here? To me this seems like a very obvious thought. Maybe we can’t stop insider trading, but certainly insider traders make a profit and I am very skeptical that it comes from professional traders instead of retail investors. This should reduce returns on investment which reduces investment, and reduce liquidity which reduces investment, and I don’t see how pricing in some of a merger premium earlier is going to increase investment in a corresponding way. Maybe the regulatory burden isn’t worth it, maybe enforcement is terrible, maybe prosecution is selective, etcetera, but the underlying case for wanting to reduce insider trading does not seem at all obscure to me.

Regarding an exchange above between Zeke and David Henderson —

David argued (as did the pioneering scholar on this matter, Henry Manne) that proscriptions against insider trading should be left to corporations and not be hijacked or otherwise overridden by politicians or government bureaucrats or courts. Zeke then responded that such decision-making would likely have to be made at the level of shareholders, but that, practically speaking (because many large corporations have many shareholders), any efficiency-enhancing rule to proscribe insider trading would not be made because of collective-action problems among the shareholders.

David then suggested an opt-out rule: have a general prohibition on insider trading until and unless a majority (or supermajority) of shareholders votes to allow insider trading for their firm.

Two points (and forgive me if I missed if these points were made elsewhere in the comments):

First, Zeke and David presume that the best default rule is against insider trading. Why? David’s rule would be desirable only if corporations generally would prefer that their insiders be prohibited from trading on inside information. It’s not at all clear to me that such a presumption is justified. If collective-action problems really do plague shareholder decision-making, and if insider trading is generally in the best interests of shareholders – then David’s rule would be harmful, not helpful.

Of course, if my second “if” above were different, then David’s rule would be helpful, not harmful. My only point here is that we shouldn’t be too quick to presume that insider trading is generally so undesirable that a default rule against it is justified.

Second, and more importantly, this discussion (including my own in the paragraphs above) overlooks another of Henry Manne’s profound insights – namely, the operation of the market for corporate control.

At the risk of summarizing too bluntly Henry’s nuanced explanation of the operation of that market, an active market for corporate shares – through, for example, mergers or hostile takeovers – solves the collective-action problem that would otherwise afflict owners of shares of large, publicly held corporations. Outsiders to the corporation – such as corporate raiders – specialize in monitoring the performance of corporations and mustering the financing and carrying out the activities that are necessary to assemble a controlling block of shares if and when incumbent managers are likely managing the corporation incompetently. The controlling block of shares is then used by those entrepreneurs who assembled it to oust the incumbent managers and to replace them with better managers. The corporation’s new controlling owners can, and presumably will, also change whatever by-laws and policies are thought to work against the best interests of that company’s shareholders.

So, if Acme Corp. ‘should’ prohibit its insiders from trading on nonpublic information but, for collective-action reasons (or due to the incompetency of incumbent managers), does not do so, Acme’s share prices will be lower than what they would be if such a prohibition were in place. The market for corporate control will then kick in to inspire a takeover of the corporation and a change in its by-laws and policies. Acme will then start to prohibit insider trading by its executives and other agents. Likewise, of course, if Acme Corp. ‘should’ allow its insiders to trade on nonpublic information but doesn’t currently do so.

David:

Thanks for the clarification – but now I owe you one. I understood where you were coming from in that reply to Zeke and yet I carelessly wrote my earlier comment without signaling that I was so aware. My apologies.

By the way, I’ve recently re-read nearly all that Manne wrote on insider trading. It’s brilliant and deep. And it shows also Henry’s openness to new scholarship, new ideas, and his all-too-rare ability to admit to being mistaken.

Link to 2009 PDF of Three Worlds Collide. Also in web format, presumably updated, with commentary.

Well worth a read for any fan of game theory and ethical conundrums, demonstrating where logical consistency fails to provide a satisfactory resolution.