Most policymakers, along with the general public, believe that insider trading should be banned. Yet straightforward economic reasoning suggests the opposite.Most insider bans should be eliminated, except for one group. Whereas insider trading done by the public is done based on better information, insider trading by members of Congress permits Congressmen to take advantage of the fact that they can vote for laws based on their stock positions. They can create bills that will benefit their positions! This is much different from trading simply on new information that makes the market more efficient. It provides members of Congress, by the drafting of laws, the ability to make their positions profitable---via force implied in their positions.
The most obvious effect of a ban is delaying the release of relevant information about the fortunes of publicly traded companies. This means slower adjustment of stock prices to relevant information, which inhibits rather than promotes market efficiency.
Imagine, for example, that the CEO of a pharmaceutical company learns that a blockbuster drug causes previously unknown side effects. Absent a ban, the CEO might rush to sell or short his company’s stock. This would have a direct effect on the share price, and it would signal investors that something is amiss. Insider trading thus encourages the market to bid down the shares of this company, which is the efficient outcome if the company’s fortunes have declined.
Under a ban on insider trading, however, the CEO refrains from dumping the stock. Market participants hold the stock at its existing price, believing this is a good investment. That prevents these funds from being invested in more promising activities. Thus the ban on insider trading leads to a less efficient allocation of the economy’s capital...
...bans have other negatives. Under a ban, some insiders break the law and trade on inside information anyway, whether by tipping off family and friends, trading related stocks, or using hidden assets and offshore accounts. Thus, bans reward dishonest insiders who break the law and put law-abiding insiders at a competitive disadvantage...
The ban on insider trading also makes it harder for the market to learn about incompetence or malfeasance by management. Without a ban, honest insiders, and dishonest insiders who want to make a profit, can sell or short a company’s stock as soon bad acts occur. Under a ban, however, these insiders cannot do so legally, so information stays hidden longer.
Thus, bans on insider trading have little justification. They attempt to create a level playing field in the stock market, but they do so badly while inhibiting economic efficiency.
Thus, bans on insider trading should be lifted for the general public and aggressively put on members of Congress. The exact opposite of how the situation currently is.
Great entry. Although I would still be a bit pissed off at the CEO if I were a shareholder (ownership).
ReplyDeleteI'm not so sure I agree with any of this. The first example he cites in my opinion is BS because the secondary market is a zero sum game. Any shares I buy must go to someone else in the secondary market and THEY then decide where to allocate that capital. Regardless of what the stock price is.
ReplyDeleteI am somewhat sympathetic the second example but still am suspicious of the conclusion.
The third example (all of these examples, really) in my view makes the case that it is beneficial for some privileged people, who are first to get the information, to profit from it. I don't know, that smacks of the bankers and crony capitalists making profit from the Fed's inflation. These insiders my not even be investors in their own corporations.
Besides, I kind of view insider trading restrictions as an extension of pari passu. As a holder of a class of securities I should be treated equally (in all manners) as any other holder. It can easily be viewed as a form of fraud that the CEO can purposely withhold information in order to maximize his personal gain at the expense of other shareowners who are entitles to the same information. 'My property rights have been violated!'
I'm all for getting rid of as many laws as possible, but this is a complicated issue and the examples this "economist" gives just aren't very convincing to this reader. In fact they seem rather wrongheaded.
--CR
Stock ownership is not a zero sum game. I could buy shares that increase the float without an exclusive seller. It is especially not a zero sum informational game also. If there is a willing seller (buyer) for my buying (selling), no matter what information is available or not, both are happy. There is no crime. Any price appreciation on a stock I own doesn't mean others lose, learn how the stock market works!
Delete"I could buy shares that increase the float without an exclusive seller."
DeleteWhat does this statement mean?
I know a little about the stock market;)
Worst thing about insider trading laws: there aren't any. It's just something judges inferred from the securities fraud statute and the Supreme Court upheld. Here's the statute used to prosecute insider trading: http://bit.ly/GItQxu
ReplyDeleteThe whole racket was just made up by overzealous prosecutors and is allowed by a spineless judiciary. Yet another reason to ditch this non-crime.
I don't understand - how is the congressman's power to make a new law any different from the CEO's power to change "the law" within his firm? Aren't they both in a position of power that puts them at an unfair advantage?
ReplyDelete