July 23, 2012 Leave a comment
When most of us hear the words “Insider Trading”, we feel a little chill down our spines. It is a bad thing of course, isn’t it? Recent insider trading scandals like the case with hedge fund manager Raj Rajaratnam of the Galleon Group reverberate through our minds. It is something that should be punished criminally, and eliminated from the markets if at all possible. But anyone especially interested in this phenomenon should really stop and ask again that age old question that has plagued market regulators – is insider trading truly a bad thing?
For that matter, do we even know what insider trading really is? In the 1980’s and 1990’s, many famous insider trading cases appeared headlining the news. This spate of illegal insider trading renewed interest in increasing regulation of these types of trades, and the question of how to define insider trading moved to the forefront. Previously, legal insider trading had been mostly defined as trades by top executives or beneficiaries of corporations or their family members. But couldn’t others outside this group obtain information that could move the stock price, and illegally benefit? And how exactly would those cases be defined as illegal? Michael Milken was one of the most famous illegal inside traders in the late 1980s, but it was not always clear that what he was doing was illegal. And how could regulation possibly define all the ways that one could obtain this inside information illegally? Congress is famous for massively long bills, but the ways to trade on inside information are almost infinite. So in 2000 a much more practical bill called Regulation FD was passed, broadly defining illegal insider trading as “anyone who trades on material, nonpublic information”.
Ok, so now we know what insider trading is. However, before I go further, it is important to make a more clear distinction between legal and illegal insider trading. Insider trading is actually legal for corporate insiders and is an active part of the marketplace, but is done in a controlled, regulated fashion. Legal insider trading is not only accepted, but is considered desirable in the markets, because it improves the chance that the stock price more fully reflects current information regarding that stock, meaning that the current stock price is more accurate (this is called in the finance literature the “price discovery” process). Who knows better than corporate insiders if their product is selling like hotcakes and orders are increasing, or if sales are slowing down and their warehouses are filling with costly inventory? So these insider trades send a great signal to the marketplace on which direction the stock price is likely to move in the near future, and what the current fair price of the stock should be. And because of improvements in insider trading laws (the biggest recently being Sarbanes Oxley in 2002), insiders cannot gain much profit before revealing their information to the general public.
Now let’s consider illegal insider trading, which is usually assumed to be harmful to investors and the marketplace. In fact, since current laws would be expected to only allow insider trading that is not detrimental to investors, it is easier to see why these illegal insider trades might cause problems. And in contrast to legal insider trading, illegal insider trading might be assumed to make the stock price less accurate (harming the “price discovery” process). Thus in a market with heavy illegal insider trading, the average investor would constantly be buying at an abnormally high price, and selling at an abnormally low price, with these illegal inside traders profiting off of the difference. This behavior would discourage average investors from trading in markets like this, causing further harm to stock price accuracy, as there would be less traders doing research on stock prices, etc. However, there is a small contingent that believes that even illegal insider trades are beneficial to the marketplace. Nobel prize winning economist Milton Friedman argued that all insider trades should be allowed for trading, even the ones currently considered illegal, as this would open the markets up to the free and unhindered flow of information from insiders to the marketplace. Stock prices would move up or down based on this increase of insider trades, more accurately pricing the stock than what happens in our current regulated environment. While this sounds good in theory, evidence of market manipulation prior to the 1930s when insider trading was less regulated may conflict with this opinion. Many Libertarian think tanks argue that the market would adjust to attempted manipulation while still allowing better stock pricing, but the debate rages on. Actually, an excellent guide to understanding the distinction between the benefits and detriments of insider trading appears in the 1987 Oliver Stone classic film “Wall Street”, in which Michael Douglas portrays a corporate raider heavily using illegal inside information. While most of the movie focuses clearly on this undesirable illegal insider trading, there is one famous scene (often called the “Greed is good” speech) in which Douglas’ character Gordon Gekko skewers the management and insiders of Teldar Paper for not personally buying into the stock, subtly suggesting that the poor performance of the firm was because “management has no stake in the company” and was thus uninterested in actually improving firm performance.
So back to the original question – is insider trading really bad? Always remember when answering that question to define exactly what insider trading is first. Under the current regulatory environment, most scholars believe legal insider trading to be a good thing for the creation of more efficient markets, while illegal insider trades are considered undesirable for establishing proper stock prices. The dividing line between the two shifts periodically with economic conditions and political parties in office, but one thing is certain – insider trading will always be with us, whether legal or illegal, so we better get used to it and try to understand it more fully.
Tony Via is a 5th year Finance PhD student at the University of Alabama, and currently resides in Tuscaloosa, AL. He is originally from Decherd, Tennessee, and worked as a mechanical engineer before returning to graduate school. His research specializations are in Investments and Market Microstructure, and he has done consulting work in proprietary trading and market impact models.