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?
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?
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.
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. :)
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.
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.
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.
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.
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.
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.
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.
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.
We changed things a bit - let me know if it is better now.
I'd favor increasing the penalties available to civil courts and contracts.
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?
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.
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. :)
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.
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.
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.
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.
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.
Can you provide some more information on this literature? I'm not familiar with it. Thanks!
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.
They already do, don't they.
Read the post: Robin said corporations could set their own rules on insider trading.
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.
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.