Should we legalize insider trading?

Henry Manne says yes:

The implications of what we already know of this “wisdom of crowds”
approach to price formation, as against the traditional marginal
pricing/arbitrage approach, are apt to be startling. We should rethink
any current policies based on a view of pricing in which we exclude the
best-informed traders and discard the wisdom of the many. For instance,
we now have a new and more powerful argument than we had in the past
for legalizing most insider or informed trading.

Since such trading clearly makes the market process work more
efficiently, it aids capital allocation decisions and informs business
executives through market-price feedback of the best predictions about
the value of new plans. Furthermore, the Supreme Court’s “fraud on the
market” theory of civil liability under the federal securities laws and
Congress’s ideas of correct civil damage claims for insider trading no
longer have any intellectual merit. The same is true of any other part
of our securities laws implicitly based on the notion of the marginal
trader as a rational arbitrageur of price.

The new approach would suggest that it is undesirable to have laws
discouraging stock trading by anyone who has any knowledge relevant to
the valuation of a security.

Here is one summary; here is the (gated) WSJ piece.  I find it hard to believe that legalized insider trading would boost the level of equity prices in the United States; I would be willing to bet against that view.  Some new developments would be reflected in stock prices more quickly but, given that most marginal investment decisions are financed by a) retained earnings, and b) debt, I doubt if this would improve resource allocation very much.  Also keep in mind that another function of equity markets is to share risk and help people save for their retirement.  Even if it is only an issue of perception, legalized insider trading won’t serve either of those ends.

For the pointer, I am grateful to Chris F. Masse.


I don't think the argument for legalizing insider trading really rests on "boosting the level of equity prices", though. It seems that the real value of insider trading (at least according to the best argument I've heard) comes from the information added to the market by the informed trader.

Lots of people have "non-public" information relevant to the market. Is it "to the detriment of other investors" that, for instance, a scientist who has esoteric information about a process is able to inject that knowledge into the market by buying earlier than others? In fact, like most government programs, insider trading laws accomplish the opposite of their proclaimed intent. They hide crucial information from the average trader. The more relevant the information, the riskier it is for those in the know to let the market know about it by participating. This is good?

"if not perfectly so." - not to be rude, but this borders on insanity - what do you even think perfectly efficient means?

The problem I see is that you are probably creating an elite class of people who benefit from this information before everybody else. Martha Stewart calls Dondald Trump, etc. If it is a rigged game for the carnies it is better not to play at all.

On the (very) positive side, would be the lack of need for enforcement. On the negative side of this, you are opening a door to a lot of legal fraud, and weird speculative runs.

People with material, non-public information who are able to profit from such do so to the detriment of other investors.

Not necessarily. If someone with inside information buys a stock, and shifts its price upwards, everyone who owns the stock and the indices to which it belongs will benefit.

Heck, would you trade before an earnings announcement if you knew that the CFO of the company was likely to be in the market as well?

Well, there's a 50/50 shot that I'll be taking the same side of the trade that he will. Sure. Why not? Anyone who works in the business should accept that some market participants have more information than others, and that more efficient markets reduce this disadvantage.

Last time I checked the selling and buying behavior of
management of their publicly identified options and shares
was public information. It has long been used as a useful
indicator about the status of particular companies (buy when
the insiders are buying and vice versa, duh).

The problem arises when this kind of buying and selling is
not public information. Then there may be a greater information
distortion in the market.

"If someone with inside information buys a stock, and shifts its price upwards, everyone who owns the stock and the indices to which it belongs will benefit."

But the insider trading is by no means necessary for this outcome. As a practical matter, all inside information becomes public information at some point, so the good news you are referring to will ultimately be reflected in stock prices, insider trading or none.

"Well, there's a 50/50 shot that I'll be taking the same side of the trade that he will. Sure. Why not??

If you or I as an uninformed person trade in a market with informed traders we will on average lose money. This is an inevitable result from the fact that trading is essentially a zero sum game, and hence a zero expected NPV game if evereyone has the same information (ignoring transaction costs) . Smart uninformed traders will therefore stay away, or at least trade as little as possible, if they know that insiders are (likely to be) in the market.

"Do you think spreads would widen if we let insiders trade?"

Yes, market makers would definitely increase their spreads. Here is some evidence to that effect:

There are several other papers showing similar effects.

But widening spreads is just one aspect of a general decline in liquidity associated with increased insider trading. In the extreme, uninformed traders will simply stay away, leaving only the insiders and no market.

"Say (or believe) what you will about adding more information, it still means that the average investor will believe that it's a rigged game -- particularly since the average investor is probably risk averse. This means less participation, less investment, lower prices and, if you actually do believe in the wisdom of crowds, might even suggest less information by reducing the size of said crowd."

I actually did my seminar paper in law school on this very subject. Not the legalization of insider trading in general. But specifically whether legalizing it or decriminalizing it would hurt the liquidity of the markets. My conclusion was that there is no evidence that legalization would affect investment in the markets. Amongst other things I looked at cross-cultural regulations on insider trading. I believe it was Taiwan Hong Kong and Japan that had either no insider trading laws or in some cases extremely relaxed insider trading laws. Their markets were very liquid and the fact that insider trading was going on did not seem to hurt investor confidence at all.

By the time the information filtered down to investors (as opposed to traders) they would be ripe for rape. Many are raped by their own brokers who can only make a living by churning.

Actually, since I think small investors should never buy individual stocks but sticks with funds, maybe this would drive investors to my point of view.

Here's a few hypothetical arguments against legalizing insider trading...all of which should be tested empirically to the extent possible before relying on them... 1. To have a wisdom of the crowds, you first have to have a crowd. Legalizing insider trading probably would create a feeling that the playing field isn't fair, and that it's not worth entering into the game. 2. Legalizing insider trading may discourage disclosure of material information, because insiders may want to keep a larger information discrepancy between the public and themselves so they can build up a more valuable position. 3. Legalizing insider trading creates a difference in the incentives for insiders vs outsiders which is particularly a problem because insiders are management that has a fidiciuary responsibility to outsiders.

Surely legalized insider trading will drive participants out of the market, with many harmful effects. Outsiders will rationally have lower bids and higher asks, if they fear they are dealing with insiders. In the extreme I suppose you could construct a model where the equity markets cease to function at all - a la "lemons."

is the likely slight and temporary improvement in the accuracy of prices worth the consequences? I don't think so.

They key question is not whether insider trading hurts stock investors, but whether there is an externality on other parties. If there is no externality, then it don't see why it should not be up to each firm to decide whether to allow their insiders to trade.

<"What if you let the company choose if it wants to be subject to insider trading regulations or not?">

This is entirely possible. It's called listing on an exchange outside the U.S.

"I find it hard to believe that legalized insider trading would boost the level of equity prices in the United States; I would be willing to bet against that view."
So would I.The first impact would be increased transactions costs [via larger bid/ask spreads]and less liquidity and more volatility.



By what logic, if we can use that word in describing the process the WSJ uses to reach its conclusions, do they exclude government officials?

Are there any other markets/asset classes that ban (don't ban) insider trading? If so, what's been the effect, on effiency, liquidity, participation by uninformed investors, and so on?

I ask, because real estate, which as an asset class, dwarfs the value of common stock, has no bans on insider trading (to the extent the concept even applies),

McDonald's, for example, may have a problem if insiders misuse info to acquire a site in advance of the firm seeking it for one of their outlets. But it's not insider trading as it would be with equities. And I haven't heard of anyone arguing that public confidence in real estate market is damaged as a result.

The real estate issue is interesting. For one thing, it is clearly not as efficient or liquid as capital markets (real estate is usually the textbook example of an illiquid asset). While there are quite extensive real estate disclosure laws in most states that essentially mimic laws against insider trading (for the sell side, at least, which is where the information asymmetry usually exists), certain information asymmetries on the buy-side might get you charged with fraud. To use the example above, if a person in the city zoning office confidentially learns that McDonalds wants to buy Plot X and then goes out and buys Plot X from its owner, that official could be charged with fraud and also sued by both McDonalds and the original owner.

On a different topic (and not to defend Manne's position or anything), but there have been a couple of occasions where office boys have been charged with insider trading. The latest were two guys working at Quad Graphics who were paid to steal early copies of Businessweek. See

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