Insider Trading is Good

Over at Knowledge Problem Michael Giberson discusses the effects of insider trading restrictions and their efficacy in general.  He links to a range of articles, notably a summarization of arguments against anti-insider trading, and then reflects upon Chris Dillow's "adverse selection problem" created by allowing insiders to trade their knowledge.

"Imagine an oil company's geologist knows he is about to discover a big oil deposit. Before announcing his finding, he and his friends buy the company's stock at a low price. The gains from his discovery therefore accrue to him, rather than to shareholders. If shareholders fear this will happen, they'll under-invest in oil companies, with the result that we'll get too little investment in resource discovery. Efficiency requires that the property right in oil discoveries lie with shareholders, not employees."

I think Dillow's adverse selection problem is seriously flawed though.  He--for some reason--contends (assumes) that there are no shareholders before the geologist makes his investment.  With this absurd assumption in place then, yes, all benefits to the discovery are transferred to the geologist and not investors. 

His argument that, "before announcing his finding, he and his friends buy the company's stock at a low price. The gains from his discovery therefore accrue to him, rather than to shareholders" is particularly faulty:

A) Someone owns the shares before the geologist buys them, and he probably didn't buy ALL the shares of the company (if he did then someone else would probably put the company in play and learn about his material information in DD).  Therefore the profits of his discovery accrue to him AND to the shareholders.  He does not profit at other shareholders' expense, he profited with them--thus aligning their interests further and reducing principal agent problems.

B) The announcement has to be made at some point--at which time medium-long term owners of the stock will profit during its gap up.  When price discovery is opaque there is no mechanism to gradually increase the price alerting potential buyers to enter the market (econ 101 people).  If the price increases gradually, as the geologist buys up shares with his insider knowledge, then other market participants are able to judge this information via the stock's price.  There is not the binary gap up and MORE people, not fewer are able to profit: those who bought shares sensing the introduction of new information to the market; AND those who sold their shares at prices between the pre-discovery price and announcement.  This gradual price discovery helps all.  Either he is big enough to move the stock everyone wins, or he isn't and it still doesnt matter that he traded.  If you (or the firm) disagree, you could either a) limit his trades, or b) pay him less because of his ability to exploit insider knowledge.

C) Volatility tends to be the enemy of efficient capital movement (e.g. today's inability to value securitized assets).  With increased uncertainty comes a higher risk premium for capital formation.  The aforementioned "gap up" is a volatile movement in the valuation of the company, and thus unattractive to most (not all) investors.  This would lead to an adverse implementation of Dillow's "adverse selection" problem.  With smother price moves, and more transparency in price discovery people are able to better predict future volatility and invest capital.

Many will undoubtedly chastise me for the counter example: what happens in the event where insiders know of bad information and dump their shares all while maintaining a glossy veneer to the public/shareholders?  Well, obviously, the exact same thing will happen.  The price will be depressed gradually--C level insiders also have to report sales, and no employees can short their own stock--alerting people to problems ahead.  It's the exact same thing as insider buying.  Would you rather an information flow, where the price decreases and you have the OPTION of selling, or, again, a binary gap down?  It's not like the current rules don't enable the selling of shares and keeping a glossy vaneer (*cough* Enron *cough*), so it would be better to see potentially troubling information built into the stock before it's too late.

All things considered, I can see moral arguments against insider trading, but I have yet to have anyone show me a compelling economic argument against it.   

Comments

[Arbitrageur]

Good thing there's still the CDS market for all your insider trading needs.

[Anon]

Your argument misses the point that without insider trading rules, medium-to-long term investors would systematically underprice the equity. Knowing full well that an information assymetry exists (with insiders ready to stock up on under-priced securities or sell off over-priced ones - and, knowing that even with a longer investment horizon buyers could get hosed by this), the natural bias would be to appropriately discount said equity.

[Anonymous]

This is flawed logic. Read what helped Akerlof win the Nobel Prize in Economics, "The Market for Lemons: Quality Uncertainty and the Market Mechanism" (1970). Asymmetric information leads to market collapse. There's also a paper called the inevitability of the SEC that's pretty good.

[1-2]

Thanks for the feedback. My thoughts are as follows:
1) @anon: I'm not sure I quite understand your argument. Why would medium to long term investors systematically underprice the security? By having a lower information asymmetry ratio the equity should be more appropriately priced, not less. The price would accurately reflect all available information, not just publicly available info. Furthermore, if you are truly a long term investor then you can't get hosed because the volatility becomes a moot point. Insider trading allows shorter-term investors to reap marginal benefits instead of the already mentioned binary price swings.

2) I read the market for lemons, maybe five times, in undergrad. If I recall correctly the argument is that since the lemons' sellers all know the condition of the cars better than the purchasers they will systematically "hose" the buyers. Again, i disagree with your analogy though because in this case the insider is able to affect the price of the security at the margin (the market's liquidity allows for this to happen). The marginal price movement--which isnt visible in private transactions like used cars--is the market signal. Asymmetric information is reduced by this fact--not increased.

Email me to debate more. Anything good I'll happily post next to this.

[Anon]

As an example, assume an investor is considering buying a stock trading for $28. Based on all publicly available information, the investor has determined (somehow...) the stock is worth $30. Without insider trading, the rational investor will buy at $28, as would other investors, up to the point where the stock traded at $30.

However, if insider trading is allowed then the investor cannot be sure whether the security is undervalued (as would be indicated by all public information) or overvalued (as would be indicated by non-public information). While a market trading off less information (e.g., public only) demonstrates a greater inefficiency ratio, it is of critical importance to note that without insider trading these inefficiencies are symmetric in nature, whereas with insider trading these (somewhat reduced) inefficiencies are not.

As a result, the investor must apply some discount to account for the fact that any non-public information will impact the market price of equity to the detriment of those who do not posses non-public information.

The same dynamic occurs for an investor looking to sell equity.

[Anon]

Why not allow insider trading with complete transperency of identity. So anyone from the CEO to the geologist to the sales rep can buy and sell whenever they want based on whatever information they have, but they must report such purchases and sales contemporaneously and electronically with SEC? Then investors can see for themselves if insiders are positive or negative, leading to more efficiency.

[Anonymous]

There are numerous economic arguments again insider trading, many backed with strong empirical evidence. Refer to Jean Tirole 2005 for a good review of the economic literature on this topic. Most new articles on the subject are fairly recent. If you finished your academic studies a while back, you might have missed out on the developments surrounding this debate within academia.

[James]

The argument has a veneer of authenticity about it, but misses the KEY point in the example. The geologist is acting as agent to the company (and therefore the shareholders). As a direct result of this, any information he discovers in that capacity is THEIR knowledge to profit (or lose) from. To not immediately pass that information on to them he would be legally not fulfilling his obligation as an agent of the firm (shareholders).

[J Aron]

"Someone owns the shares before the geologist buys them, and he probably didn't buy ALL the shares of the company"
This logic is flawed. Is insider trading was legal he would be getting every one he knew to buy shares in the company.

[1-2]

@7:10 - A) god I hope youre a trader, otherwise you're up to early.
B) I agree, the knowledge posessed by the geologist is the company's property. But you haven't laid out ANY argument for how the existing shareholders are hurt by his knowledge and trading. If a well is worth $5/share then the stock will trade up to that point (85=>90). The question is whether it is a gradual increase in shareprice--allowing others to profit at the margin--or a "gap", where only existing shareholders profit. Either way, the company can mandate the geologist to transfer his knowledge anyways, with no affect on the company's finances. That's a complete non-issue.

C) @7:58: exactly! If he had everyone he knew buying the shares then the price would gradually increase, thus giving information to the market! You killed your own argument. I love it!

I'm hungover. Love you all.

[miami]

'as a direct result of this, any information he discovers in that capacity is THEIR knowledge to profit (or lose) from.'

Shareholders ARE profiting. Your reply is nonsensical.

'To not immediately pass that information on to them'

That is what currently happens. Shareholders do not get updates from key insiders every day. Insiders do NOT pass on that information immediately.

By eliminating rules that prevent the flow of information to the marketplace, shareholders would find out [assume mandatory disclosure of insider trades for a wider spectrum of insiders]
immediately, as opposed to having to wait for Q-end, or never finding out in many cases.

[1-2]

Miami, you realize that I wasn't the one who wrote those sentences, right?

[Anon]

@ 1-2

You didn't respond to my post yesterday, so I'll include it again below. As stated, the shortfall of your insider trading argument rests on the idea of information asymmetries being symmetric versus biased:

While a market trading off less information (e.g., public only) demonstrates a greater inefficiency ratio, it is of critical importance to note that without insider trading these inefficiencies are symmetric in nature, whereas with insider trading these (somewhat reduced) inefficiencies are not.

As a result, the investor must apply some discount to account for the fact that any non-public information will impact the market price of equity to the detriment of those who do not posses non-public information.

[1-2]

@Anon - so by logical extension of your argument efficient markets thrive on NO information? The symmetry is the same regardless of whether insiders are allowed to trade or not. Why? Because the insiders will affect the price of the stock, not just their own onwership interest, thus leaving future price movements to be essentially random. All insider trading does is allow for a) price discovery; and b) reduced "gappage".

[Anon]

Efficient markets do not thrive on "NO" information, but they do thrive on a level playing field (where investors trade based off of the same info). Effective disclosure provides transparency, so more and better public disclosures make markets more efficient.

However, if you let participants with "better" information trade with those who have "average" information, equity on the whole becomes underpriced because "average" investors (i.e., non-insiders) will know that whatever private vs. public info inefficiencies exist will only work against them (as opposed to for or against them).

As a consequence, the most efficient system is one that provides the most effective disclosure to all non-insiders (i.e., providing the best "average" information), and only allows trading between members of this equal field.

[Anon]

I think most of the commenters have said it already, but this author completely misses the point.

Suppose stock is at 3 but non-insider values it at 5. His "5" value includes the chance that oil will be discovered. So insider comes by and offers with 5 with inside knowledge there is oil. Investor sells, thinking this is a level and fair playing field. Wrong! Stock goes to 10. You can't tell me investor isn't harmed. Of course he is. He will never win. His value was 5 based on a chance of the stock going to 10 and a chance of it going to 0. Here he never got his 10 -- he only got 5 even though he won his bet.

[M.D. Fatwa]

There are numerous theoretical and empirical economic studies on the problem with a market where insider trading is commonplace. See, for example, Bhattacharya and Daouk, "The World Price of Insider Trading," (http://faculty.fuqua.duke.edu/~charvey/Teaching/BA453_2005/BD_The_world.pdf) which compares the cost of capital in countries which enforce insider trading laws versus those which don't and noting a systematic decrease in the cost of capital when a country starts cracking down on insider trading.

[miami]

Why on earth should I be prevented from finding out information because a Duke professor thinks it may help lower the WACC?

That's one of the most nonsensical responses I've ever seen.