Yglesias Gets It

What you hear is that [insider trading] rules are in place to protect investors from getting ripped off. But I don’t think this really stands up to scrutiny. That makes it sound as if the purpose of the stock market is to create an entertaining casino that people want to participate in, thus letting the house get a bigger rake. And of course it’s true that if that were the purpose of the stock market you would want rules against insider trading. But that’s not the purpose of the stock market—at least not the legitimate purpose. …

I looked around on this and found that Fama & French believe in the insider trading ban. Frankly, when you find a regulation that business-friendly academics who never want to regulate anything like, I’m even more inclined to believe that this is a worse idea than it sounds. Basically it’s a government seal of approval on stock market speculation, when the government should not offer any such seal. (more)

I used to give more benefit of the doubt to the argument that more insider trading would produce less net stock investment.  But that effect seems pretty weak to me, and firms which thought it especially an issue for them could ban insider trading via contract.

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  • misterxroboto

    i’m really not sure how the casino factors into this.

    insider trading bars people from using material non-public information because it means you can take advantage of knowing what will happen with a higher likelihood.

    now this isn’t because you’re smarter or because you have better technology. insider information is what isn’t available to others (if it were, it would be public rather than non-public).

    fama and french hate insider trading because the EMH limits itself to publicly available information. insiders screw up their entire hypothesis.

  • Lo Statuz

    I suspect the idea of insider trading triggers the cheating detector that evolutionary psychologists say we have.

  • frankcross

    Why do you think the effect on investment is such a weak one?

    Contracts are not an answer because there are great transaction costs for investors to examine the contracts and discern the nature of the scope of the contract prohibition (as opposed to one uniform law). More serious, there is no guarantee that the company would attempt to enforce the contract, and investors would lack the standing to do so. How would an investor know if the company just wrote a contract prohibition and then told the insider: “go ahead and insider trade, just cover your tracks so it’s not obvious.”

    • PaulG

      Clearly the point of doing it by contract is because the companies want money from investors. If they felt that investors wouldn’t invest if insider trading were going on, it would be in their best interest to strongly signal that their executives were not allowed to undertake these behaviors. One way to do this would be to have strong contracts which are strictly enforced.

    • Jess RIedel

      Frank, in addition to what Robin Hanson said, there’s this: If you are really worried about things being too complicated, then just modify the law to state that all firms must clearly register as “insider-trading” or “no-insider-trading”. Then, we would apply our identical anti-insider-trading laws only to the latter (with the same effectiveness as we have now).

  • kevin

    Interesting, I always assumed that the insider trading ban was created to remove the incentive executives and investors could have to deliberately wreck the company and short the stock. Now that I think about this, that scenario probably isn’t very plausible.

  • It it were legal, banning insider trading via contract would surely be widely attractive – if the contracts covered everyone, were sufficiently punitive and these facts could be demonstrated to prospective shareholders.

  • Douglas Knight

    The empirics are clear. Insider trading laws are not optimal, but the effect is not “pretty weak.”

  • Lo, I suspect similarly, but the details are everything.

    frank, firms are complicated things; if you can’t be bothered to look at their details you shouldn’t be betting on them. Of course like most rules, rules against insider trading would need teeth and outside enforcers.

    Douglas, what, not even a link?

  • frankcross

    Jess, that’s a decent argument. I bet every firm would register as no insider trading, though.

    Robin, that’s true, but the more details mean more transaction costs and there’s inevitable uncertainty about individual contract meaning. And you don’t come to grips as far as I can tell with the failure of contract law and inability to enforce the restriction, however severe it might appear to the investor.

    Some of the research was done by Laura Beny. I think LaPorta et al may also have tested this.

  • Cowen linked to this earlier (though I had to use google’s cache to view it), but Henry Manne has a reply to Fama/French on insider trading.

  • Insider trading is banned in PUBLICLY TRADED companies. I don’t believe it is banned in private companies. There are limits on exploitation of intentional information asymmetry in all trades, I think, with fraud laws being the ultimate limit.

    Publicly traded companies are essentially agreeing to a broad range of behavior limits in exchange for access to a large pool of stupid money.

    We don’t require (or even allow) every idiot in New York City to carry a gun in order to protect himself from street crime, instead we have “regulators” (police, jails, courts) who protect the large pool of stupid people who then gain access to New York. Essentially, deciding to go in to New York to make money or be entertained or whatever is agreeing to be in that environment. The environment appears to be successful largely as a result of the high level of “regulation.”

    Similarly to the public stock markets. Whatever your Austrian theory might be, no one can argue against the coincidence of 1) tremendous regulation with much of it about transparency, including insider trading restrictions and 2) tremendously large piles of money available in these markets.

    Robin speaks dismissively of the purpose being to build an attractive casino. But of course whether you approve or disapprove, it is only the attractive systems we spend much time discussing because these are the ones which are heavily populated, these are the ones that matter. Bans on insider trading and other regulations and laws towards transparency, limiting information asymmetry, will ALWAYS be imperfect. But the evidence on its face is that a lot of limits are way better than a few at creating a gigantic pool of stupid money, some of which, perhaps accidentally, winds up used for the good of society.

  • Justin

    While it is true that allowing insider trading would provide more information to the markets and thus make price discovery more efficient, it would provide much stronger incentives to prevent information that is today routinely disclosed from becoming public. The officers of a large corporation would have a strong incentive to ensure that any bit of material public information is given to his network of investors as far in advance of that information becoming public as possible to allow those investors to buy or sell long before the information became public. Each of them could generate large private gains either in direct payments from their network of investors or, more realistically, in various sorts of in-kind consideration. The officers of the largest corporations could presumably make far more bartering inside information in their company than the company itself would be willing to pay them when you consider the value of that information to large hedge funds and allow a legal bidding war to take place.

    The possibility of insider trading would also tend to make the market far more volatile and make panics more likely. If I see a family of fund managers selling off their positions in a company, there are many possible explanations today. If insider trading were legal, however, you’d see rampant and credible rumors that the company running the funds knew something material which could easily set off a panic. Obviously, not every sale would set off a panic, but it increases the probability substantially.