Why Insider Trade Bans

My colleague Don Boudreaux had an oped in Saturday’s WSJ, on “Learning to Love Insider Trading.”  The economic case against banning insider trading seems strong, yet the public overwhelmingly wants bans.  Why?

Well first ask: why do we speculate in financial markets, if on average we’d make more money in index funds?  Probably for the same reason we compete in sporting contests: because a chance at either the thrill of victory or the agony of defeat looks better than not even trying.  We use both financial markets and sporting contests to signal our ability, and not trying sends a bad signal.

Relative to sporting contests, speculative contests benefit society via side effects: prices get more accurate, letting us better allocate resources.  But alas another side effect is that we prefer to regulate speculation to make it “fairer,” even if this makes it less effective at allocating resources.  Insider trading bans are a good example.

Obviously individual firms need ways to limit the damage their employees and suppliers might do; they need to watch for theft, bribes, sabotage, self-dealing, and more.  Contractual limits on when such insiders can trade company stock can help this effort, and central registration of who trades what can help enforce such contracts.  But beyond this, firms have little use for our broad laws against insider trading; before our broad bans were enacted, few firms chose to contractually limit their employees’ trading.  Insider trading laws are mainly there to satisfy public sensibilities.

Without such laws, some amateur traders might get discouraged and instead compete via sports, music, or poker.  But there’d be about as much total investment, perhaps more concentrated in index funds.  Even if fewer amateurs hunted for price errors, since professional speculators could hunt more freely, my guess is that on net prices would be more accurate.

Furthermore, even with laws against insider trading, the speculation game is and must remain ridiculously uneven.  Today most inside info gets into prices before official announcements, and well-connected well-organized investment groups are vastly better equipped to find and exploit pricing errors than almost all amateurs.  It is just crazy to see financial speculation is any remotely like an even sporting contest.

But if we must have laws giving the appearance of competition among equals on insider trading, let me suggest a much milder rule that should achieve the same end: just require insiders to announce their trades say twenty four hours in advance.  If such trades are informative, the price will have moved before their trade, and such trades won’t on net make a profit.

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  • Boris

    > why do we speculate in financial markets, if on average we’d make
    > more money in index funds?

    Because your typical tax-advantaged investment vehicles (401(k)/403(b) plans, 529 plans) commonly do not offer any index funds. IRAs are a more mixed bag. Oh, and of course some people speculate perforce because they’re paid in stock or options. Unless they’re high up in their organization, they probably don’t benefit much from insider trading either.

    Last I checked, most people’s stock ownership is in fact through their 401(k)/403(b) plans. Has that changed?

  • ravi hegde

    Brilliant! Although, smart men will always realize that there really is no such thing as a level playing field. Unfortunately most of these laws are in place more for the appearance of equality (or shall we use your lingo .. they are just signaling of a fair economy).

    • Jayson Virissimo

      What is a “fair economy”, one in which everyone has the same information?

  • Christian McClellan

    My 1L property prof and I have discussed this. Even though he seems to concede that it might keep information out and that it is a transfer to the traders (as you point out, the next best information holders so to speak). He believes traders wont do the work of making markets if other players have better information, and the empirical work connecting insider trading regulation and lower cost of capital is his proof.

    Since the guy is sharp, I have been trying to collect my arguments before bringing it up again. I think the argument must be that low cost of capital for its own sake isn’t the measure of capital markets, but its not yet totally clear why.

    • Andy

      Can you provide some more information on this literature? I’m not familiar with it. Thanks!

  • Nikhil

    If markets incorporated the information in the 24 hours following announcement, why would insiders follow through on their trades? And if they were forced to follow through on a zero-expected-profit transaction, why would they execute the trade in the first place?

    You can’t show your cards in poker before your opponent bets.

    • http://www.abs-usa.com Floccina

      I presume that they could place limit orders 24 hours in advance but would not be allowed to change the market order.

  • kebko

    I’ve alway been amazed at how much human psychology has to do with mispricings. Most of the mispricings I notice are situations where the insiders have plenty of time & opportunity to buy up shares after the story is clear to everyone inside & outside the company who cares to figure it out. It’s not news or information that keeps people from buying, but psychology. And, insiders don’t differ from outsiders in that respect. Also, these situations are frequently about pricing uncertainty, and insiders dealing with uncertainty with their employment don’t want to leverage more with their savings on the same uncertainty, even if the risk/reward is very favorable. I think frequently, insiders just feel like the market has a mind of its own, and they don’t have faith that price will strictly follow performance.
    So, outside of specific situations where a single contract or event will make a big difference for a heavily traded company, I agree that we’d see very little difference. Heavily traded stocks already react to whispers on the street, and lightly covered micro-caps can go months after public knowledge of a major event with little reaction. I’d rather see insiders get bonuses based on trading, if it replaced the excessive options bonuses they get now.

  • Michael Turner

    “… just require insiders to announce their trades say twenty four hours in advance.”

    If this could be made reliably informative, well, sure, fine, great. But can it be?

    Let’s say I want to dump my company’s stock because I know there’s been executive malfeasance. Regardless of whether my hypothetical employment contract permits me to trade on such information, I might face quite a few compelling disincentives to have my trade known as such. For one thing, the trade might be taken as a signal that I’m aware of executive malfeasance (since my firm’s fundamentals seem otherwise sound to the market), and I might not want anybody at my firm to know that I know this, especially if my plans to jump ship haven’t yet reached fruition. I certainly wouldn’t want the executives I’m implicitly fingering with my trade to know that I know of their malfeasance. For that matter, I might not want anybody at any new job to ever know I did this — if I profit from treason at one job, I might do it at another, and sometimes work requires you to be thicker with thieves than you want to be, just to get by.

    So I “consult” for somebody, and they trade my firm’s stock on their own account, and give me 90% of their winnings as my “consulting fee.” We can arrange that the “consulting” contract “begins” while I’m “between jobs” — I get paid off later. Somebody else besides me has become an insider in the process, but how does anybody ever prove that, unless somebody squeals?

    It’s not just the information that an insider has moved in a certain way. It’s also the information that somebody who has repositioned is, in fact, an insider in the first place. That’s a status that can change in one short phone call, and among close friends or family such a status change can require no contract negotiations at all, much less any publicly known contract details.

    This sort of behavior contributes negligibly (if at all) to price discovery, and it enriches undeserving people who, by way of social connections only, happen to be able to buy these special, high-yield lottery tickets. So if somebody’s resulting envy at someone else’s ill-gotten gains prompts them to tip off regulatory authorities, why should Joe Q. Citizen be anything but happy that some undeserving people got caught and punished? Why would Mr. Citizen want there to be no deterrent to such behavior, even if sanctions only deter a small minority of perpetrators? His revulsion might have nothing whatsoever to do with whether Mr. Citizen trades stocks himself, but everything to do with the sense of what makes for a fair society.

    Schumpeter outlined a broad scenario for how capitalism might reach the end of its tether. Thankfully, most of his economic preconditions haven’t been met. But he held out the grim possibility that, short of meeting such purely economic preconditions, it might be politically rejected in democracies because of mass revulsion against the social order capitalism engendered.

    Insider trading is reviled because it implies (reveals?) a social order that citizens in a democracy tend to find repellent. Even a convincing argument that insider trading bans make no difference economically makes little difference in citizen perceptions — the behavior still looks repellent to them. So, what might seem to an economist to be a regulatory regime for insider trades that’s motivated only by impotent (in market-moving terms) moralizing might actually help give most citizens a sense that the system is, overall, as fair as it can reasonably be. Sometimes even (mostly) impotent effort sends a stabilizing signal, sometimes it lends capitalism political legitimacy during its recurrent crises (and is there any doubt we’re in one of those crises now?) Sometimes mere effort matters because of the statement it makes. The net might be positive for free(r) markets.

    I’m fascinated by the idea of truly open, transparent market systems — markets in which there are no surpise unveilings of new products because all development is open sourced, and where all corporate accounting and B2B transactions are in the clear as well. My sense is that capitalism would, on the whole, operate far more smoothly and deliver more value — i.e., I have a feeling that the concept of “proprietary information” is only locally optimal for the firm, and is otherwise a drag on the system globally, in welfare economics terms. At the same time, though, I suspect the whole idea of perfect transparency might be a mirage, utopian, not achievable, at least not in my lifetime. But that, too, is only an intuition, and I wouldn’t mind be proven wrong.

  • http://graehl.posterous.com Jonathan Graehl

    Jeff Matthews attacks the pro-insider-trading argument (I can’t judge how effectively).

    • http://permut.wordpress.com/ Michael Bishop

      Not too effectively. In my opinion, the key issue is how enforceable the current law is and how enforceable corporate contracts regulating insider trading would be. He doesn’t give us evidence on that.

  • Douglas Knight

    Yes, there are probably better solutions than no laws or broad laws, but this is wrong:

    Without such laws…my guess is that on net prices would be more accurate.

    We know what happens without insider trading laws, because we can look at East Asian markets and they are awful. Not only do insiders loot the companies, but also the markets are more volatile, making it rather implausible that they are more accurate or that capital is better allocated.

    • Jayson Virissimo

      Are you saying that if insider trading was outlawed in East Asia, then their markets wouldn’t be awful and that they be measurably less volatile?

      • anon

        We observe that the absence of insider trading laws allows the insiders to extract rents and hide/obfuscate information. Yes, there are other differences between East Asian and Western countries, but this is fairly convincing evidence.

    • http://hanson.gmu.edu Robin Hanson

      Yes lots of our regulations do help prevent insiders from stealing from firms, but that doesn’t mean all of our regulations do this. Comparing our firms to East Asian firms just compares the entire package of regulations.

  • Psychohistorian

    The incentives provided by unlimited insider trading would probably encourage confusion and misinformation, rather than transparency. Admittedly, there are certain specific circumstances – such as where every insider knows the company is doomed – where such trading would generate a more efficient outcome. However, making insider trading legitimate would create huge incentives against broadcasting information accurately or coherently, and it would encourage employees with privileged information to hide or obfuscate it.

    Also, it seems like it would make mergers and acquisitions more nightmarish than they already are.

    • http://hanson.gmu.edu Robin Hanson

      I didn’t propose unlimited insider trading – I said individual firms should be able to limit their insider’ trades by contract.

      • Concerned Citizen

        Unless you are proposing doing away with personal-bankruptcy laws (which would also require amendment to the anti-slavery Constitutional-amendments ), how will contracts be effective? Heads I make millions of dollars; tails I lose nothing remotely close?

  • Jayson Virissimo

    “The incentives provided by unlimited insider trading would probably encourage confusion and misinformation, rather than transparency.”

    Shouldn’t the burden of proof be on those who claim that a law is needed, not why it is not needed?

    • fburnaby

      I think you’re generally correct. However, given that a law already exists (though admittedly, it never should have in the first place, without having been “proven”), it might make more sense to place the burden of proof on those who want to change it. If the system is only partially broke, it’s only worth so much risk to try and fix it.

  • botogol

    I was surprised by..

    before our broad bans were enacted, few firms choose to contractually limit their employees’ trading.

    Is that right? Is that researched anywhere, or just personal recollection?

  • http://www.intrade.com John Delaney, CEO, Intrade

    Robin,

    I was questioned about insider trading and prediction markets by the guys at Freakonomics some time ago.

    What I said then still applies.

    “If insiders have information, then getting that information reflected in the market increases the quality of the information. I know this is not the conventional view concerning insider trading, and I am not arguing wholesale adoption or acceptance of insider trading. But we all know that, in the real world, insiders trade on inside information. We have even had markets on insider trading. Our view is to get the best information available into the market while we make sure there is some fair protection for outsiders.”

    http://freakonomics.blogs.nytimes.com/tag/john-delaney/

    Further, I have gone on record several times saying “so long as insiders identify their orders then it seems that such [insider] information and trading is in everyone’s good.”

    http://www.intrade.com/forum/?forum=/intradeForum/posts/list/3202.page

  • Siddharth Sharma

    this is an insanely silly idea.

    it is completely obvious that top executives will be able to make far more than their salaries by engaging in insider trading. it distorts their incentives away from maximizing shareholder value to maximizing their own trading profits on the company stock.

    as a simple example, the 2008 stock market crash of financials might’ve been preponed by this rule(efficiency), but each CEO would’ve made hundreds of millions shorting his own stock and stock futures and left with the booty.

    • http://permut.wordpress.com/ Michael Bishop

      Read the post: Robin said corporations could set their own rules on insider trading.

      • http://www.rationalmechanism.com richard silliker

        They already do, don’t they.

      • Siddharth Sharma

        Yeah, i saw that, but to me allowing corporations to set their own rules sets up the ground for a lot more corporate governance problems, as if there isn’t draining of the corporate treasury by top management already. the cost of drags and frictions of perverse incentives that might get set up far exceeds any gains in inefficiency, which are miniscule at best.

        It’ll stop one Enron but will create multitudes of other scandals.

  • http://t-a-w.blogspot.com/ Tomasz Wegrzanowski

    before our broad bans were enacted, few firms choose to contractually limit their employees’ trading.

    Is it because this is essentially impossible to enforce by contract, while sort of possible to enforce by SEC?

    Is there any reason for shareholders to allow insider trading? It would lead not only to shareholder loses, but also to spectacular conflicts of interest.

    • Douglas Knight

      Firms not subject to insider trading laws do list on foreign exchanges, voluntarily subjecting themselves to such laws. If the firm does business in the US, it may be directly subject to the SEC, but purely local firms do list; they appear to me to be promising to enforce the rules by local contract law, subject only to the thread of de-listing.

      Maybe it’s just a charade, but it looks to me that contract law is sufficient. I think the problem is coordination. Investors know what the NYSE rules are and invest in such firms, but they wouldn’t notice (or trust?) if a firm made up its own rules. Maybe they could form associations with uniform lists of rules and some policing. But they don’t, which suggests that either the costs of branding such organizations is too high or that they don’t want the rules and accept them at NYSE to get at the rest of what’s bundled on that exchange.

      (bogotol: this is the answer to a question related to yours, not about the old days, but about firms currently not subject to such laws.)

  • botogol

    by definition, surely, it’s shareholders that are *doing* all the inside trading.

  • http://williambswift.blogspot.com/ billswift

    Robin, you missed the biggest beneficiaries of insider trading laws, as indeed most laws; environmental regulations, drug laws, gun control laws, etc, etc – this is how gov’t increases its power.

  • Quant Trader

    Although restrictions on insider trading do limit volatility (a simple comparison is equity vs commodity markets) whether they improve the accuracy of pricing is still, for me, an open and highly subjective question.

    Right now we are going through ‘earning season'; when companies release earnings information before or after the close, when markets are illiquid and therefore the trading looks volatile. Without fail, every season, there are stocks that ‘surprise’ analysts and/or the market, but it seems illogical that the value of stock should change several percentage points within a matter of seconds. The information contained in the earnings report was not aggregated/computed/processed within that second, but was present to the company for several days, but NOT disseminated to the market. Limits on insider trading benefit higher-frequency/mean-reversion/market-action/liquidity-providing trading (what i do) at the expense of value investors. It limits local (time-wise) volatility, (so that your grandma always has a penny-wide market 9:30 to 4) at the expense of global volatility (near and far ?).

    We should call them ‘informed’ traders and change the perception.

  • http://timtyler.org/ Tim Tyler

    Requiring insiders to announce their trades twenty four hours in advance would mean that others would benefit from them revealing information.

    It would destroy their incentive for revealing the information. The result would be that such information would not be revealed. This seems to be an relatively undesirable outcome – though it is better than an outright ban.

  • Noumenon

    I’ve decided to complain, after the umpteenth time I’ve hit “alt-D” and gone down to the comment box instead of up to the address bar. First, no other site I know of hijacks the key this way. Second, no other comments program I know of supports the “del” tag — I’m not even sure what it does. Is anyone so attached to it we couldn’t get rid of the thing? Or at least change the javascript so it only works if your focus is actually in the comment box and not when you’re at the top of the page.

    • http://hanson.gmu.edu Robin Hanson

      We changed things a bit – let me know if it is better now.

  • Noumenon

    PS: after writing that comment and reviewing it, I decided to go to althouse.blogspot.com and hit Alt-D again. It’s such an instinct. This doesn’t affect me at home because I use bookmarks, but at work I have to use the address bar.

  • peatey

    The whole point of insider trading in regulated security market can be seen by looking at the laws: “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.” It is about making sure that the insiders (management or other employees) do not act contrary to the interests of the outside-owners of the company.

    In this case, due to the much larger potential financial rewards of insider trading, the goal of price discovery is not as important as the goal of minimizing agency problems.

  • Douglas Knight

    No, peatey, since the text of the law is completely ignored by those who enforce it, the text tells you nothing. Celebrities like Martha Stewart or Michael Milken are rather more likely to be prosecuted than those in breach of fiduciary duty. People who sell stock on inside information are more likely to be prosecuted than those who buy.

  • peatey

    Douglas, the quote is directly from sec.gov, and you’d see that phrase in every one of SEC’s insider trading complaints filed. While not perfect, that phrase is in the minds of the prosecuting attorneys rather than being “completely ignored” as you say. Please overcome the bias of the availability heuristic. :)

  • http://infiniteinjury.org TruePath

    I’m simply unconvinced by the economic arguments here. In particular without insider trading rules there would simply be too much of a temptation (even unconsciously) for high ranking employees to change their official behavior for their private benefit and thereby imposing inefficiencies on their company.

    Ultimately the justification for insider trading laws is that civil remedies are totally incapable of removing the moral hazard that insider trading presents. The reason companies didn’t have their executives sign contracts barring insider trading may simply be a failure of corporate governance but even assuming the corporations were acting rationally this only demonstrates these contracts wouldn’t be effective at eliminating the moral hazard of insider trading. A simple contract wouldn’t grant the company the power to engage in intrusive investigations of a third party merely because they make sucpiscious large trades before big corporate deciscions. That party didn’t sign the contract. So any executive who wanted to make money by manipulating corporate deciscions could simply funnel the trades through a third party and run little risk of penalty.

    Moreover, contract law only provides for civil penalties and these are likely to provide insufficient deterrence. An executive willing to screw over the company for private gain will realize that, given the expense and uncertainty of litigation, even if the company later sues him they will probably just settle the case for a fraction of his profit.

    In short I take the argument for insider trading laws to be that the only effective way of eliminating the moral hazards is if the government has the power to investigate any suspicious trades and impose jail time.

    Also the proposal to require executives to announce their trades 24 hours in advance would make things much worse. In the pure insider trading case executives can straightforwardly turn their information about corporate plans/status into private financial gain. By imposing a 24 hour public announcement requirement you eliminate the incentive to merely distribute information while leaving manipulation of corporate decisions as the only profitable strategy. As long as my planned stock purchases reliably indicate good news for my corporation I make no money so instead I might want to disguise my activity through regular camouflage purchases signaling nothing. However, I think even this does me no good if I’m only a passive informed player as the market will simply adjust the stock prices up before my purchases based on the conditional probability of good corporate news given my trade and then drop the share price again before I can sell. I can’t make particularly large purchases when I know there is really good news since the market will simply decode this signal so my gains on purchases based on inside information will be offset by my losses on the camouflage trades. However, I believe (though I haven’t worked through the complex game theory) that I can still make money by choosing if the corporation should make good or bad choices based on my overall market position.

    • http://hanson.gmu.edu Robin Hanson

      I’d favor increasing the penalties available to civil courts and contracts.