Thursday, March 22, 2012

In Defense of Insider Trading

From Harvard Professor Jeffrey Miron (Hat tip: Bob Wenzel)

Most policymakers, along with the general public, believe that insider trading should be banned. Yet straightforward economic reasoning suggests the opposite.

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.

Whether these efficiency costs are large is an empirical question. Short delays of relevant information are not a big deal, and the information often leaks despite out the rules. Thus, the damage caused by bans is probably modest. But efficiency nevertheless argues against a ban on insider trading, not in favor.

And 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.

Bans implicitly support the view that individuals should buy and sell individual stocks. In fact, virtually everyone should just buy index funds, since picking winners and losers mainly eats commissions, adds volatility, and rarely improves the average, risk-adjusted return.

Thus, if policy is worried about small investors, it should want them to believe they are at a disadvantage relative to insiders, since this might convince them to buy and hold the market. Bans instead encourage people to engage in stupid behavior by creating the appearance – but not the reality – that everyone has access to the same information.

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

Information will always be asymmetric.

People do not read news or even mandated ‘public disclosures’ at the same time or at similar degrees. And people’s interpretation and absorption of information will be always be distinct.

I don’t read the newspaper by choice, so I am at a disadvantage on information or facts disclosed. Also, readers of broadsheets have different preferences, e.g some value the business section, some read sports, some prefer entertainment and so forth…

Yet this deficiency in information does not deprive me of the necessary knowledge required for investing overall. In short, the desire for information is about tradeoffs and preferences. Legal mandates will not equalize information dissemination.

And this applies to insiders as well.

The price channel is always the best medium for information (economic or fundamentals).

Importantly, a ban on insider trading or attempts to equalize information through restrictions of insider knowledge does not attain the political objectives intended, as pointed by Professor Miron. In reality, such regulations tilt the balance to favor transgressors.

Insider trading bans is another example of feel good arbitrary laws which in reality are ambiguous, uneconomical, and repressive, i.e. can be or has been used to intimidate or harass individuals or entities for political goals rather than to attain market efficiency.

Yet the ultimate violators of insider trading are central banks who have been manipulating the financial markets, through various means (QEs, swaps, zero bound rates, subsidies, etc...), all to the benefit of the banking system and other Fed cronies, as well as, regulators who erect walls of protectionism to protect favored political entrepreneurs (cronies) which enhances their company's stocks values.

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