Undercover Economist

November 1, 2013 12:17 pm

What’s so scary about insider trading?

‘The awkward truth about the practice is that it’s far from clear that it should be illegal’

It was Halloween on Thursday, so let’s meet a frightening ghoul who haunts our financial markets: the insider trader. The Halloween metaphor is not mine but that of economist Donald Boudreaux, who asks if the insider trader is a genuinely dangerous monster or a comical apparition in a fright mask, fit only for the scaring of children.

Attacking insider trading has a singular advantage for regulators and journalists alike: short of swiping money from the cash register, it is the simplest financial crime to understand. The frauds perpetrated at Enron or, a generation earlier, the Equity Funding Corporation, defy any simple explanation. Insider trading – making money by trading on confidential information – is an easy sin to attack. Yet the awkward truth about the practice is that it’s far from clear that it should be illegal.

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A school of thought on the libertarian wing of economics has long argued that insider trading is at worst harmless and perhaps even beneficial. The most famous proponent was the late Milton Friedman; more recently the likes of Boudreaux, a professor at George Mason University, have called for its legalisation.

The case for legalisation has several pillars; let’s consider three. First, despite intensive monitoring, it’s hard to detect and even harder to prove. Much insider trading clearly occurs without detection – why else does the share price of acquisition targets tend to rise sharply before the acquisition is announced? And people with inside information can often profit simply by not taking action when the uninformed take actions they later regret.

The second point in favour of legalised insider trading is that market prices are supposed to reflect all available information, the better to allocate capital. Insider trades simply hasten that process. This argument is not hugely persuasive on a day-to-day basis but there’s certainly a case that insiders at Enron or the Equity Funding Corporation might have exposed misdeeds sooner if they had felt able to profit by short selling the stock. (A footnote: Ray Dirks, the analyst who did a great deal to expose the Equity Funding scandal, was pursued for insider trading of Equity Funding stock before being acquitted by the US Supreme Court.)

The final defence of insider trading is that it’s a victimless crime: if you want to sell your shares in Tim Harford Corporation, and I know that record profits are about to be announced, then my swooping in to buy your shares does you no harm: you would have sold them anyway, and you received a better price because I was willing to buy.

The common sense reason to ban insider trading – that it just doesn’t seem fair – is flimsy. So is the argument that small investors won’t play the game if they feel it’s rigged: small investors are at a disadvantage, anyway, and should see that disadvantage with clear eyes.

 

But there are two reasons to ban insider trading that seem compelling, neither of which receive enough attention in this debate. The first is that insider trades raise the cost of being a market-maker. When secret good news is in the air, insiders will snap up stock. Market-makers will be left holding none, just as the price is rising. Conversely, insiders will dump shares on market-makers just before disaster is about to be revealed. The spreads that market-makers offer must be wide enough to reflect this risk; consequently, we all pay more because of insider trades.

The second worry is that if managers can trade easily on inside information, they have an incentive to take big risks. If you could place bets after the roulette wheel had stopped spinning, you’d spend your days down at the casino. Even if insider trading might make financial markets more efficient, it might also encourage reckless decisions in the rest of the economy. That possibility alone is enough to give me nightmares.

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The Undercover Economist Strikes Back, by Tim Harford, is published by Little, Brown

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