It's Time to Make Insider Trading Fully Legal

The newspapers in recent months have been full of bombshell stories about insider trading on Wall Street. According to an account in the Wall Street Journal, "the investigations, if they bear fruit, have the potential to expose a culture of pervasive insider trading in US financial markets, including new ways nonpublic information is passed to traders through experts tied to specific industries or companies."

The basic argument made against what its detractors call "insider trading" is that the ability to act on nonpublic information creates an unlevel playing field that decreases faith in the stock markets themselves. If access to information is made equal, small investors will allegedly feel more comfortable placing their savings in the markets.

One problem with the above theorizing is that what most deem "insider trading" has never been defined by lawmakers or the courts. Worse, not considered enough is how both the economy and investors are harmed when necessary information is obscured, thereby perpetuating unrealistic share valuations.

Ultimately, it should be said that to ban insider trading is to block use of the very information necessary for markets to function properly. The better solution is to cease prosecution of what is already vague, and in the process reward market sleuths whose efforts will ensure properly priced shares, and in the case of poorly run firms, no further waste of capital.

What is insider trading? Most among us might presume that insider trading is a simple act that involves investing based on nonpublic information. University of Chicago professor Daniel Fischel has noted in his book Payback that "Neither the SEC, Congress, nor the courts have yet, up to the present day, been able to define what constitutes insider trading."

This shouldn't surprise us. Whatever our investment expertise, it's fair to say that most of us, when we buy or sell shares are doing so based on a tip or hunch we think is unique.

A small investor who visits a Best Buy followed by a trip to Target around Christmas might make a stock purchase in one or the other based on shopper traffic experienced while in each. Presumably this experience would give the shopper an information edge over investors who are less mobile or don't live near the stores in question. It's surely logical to act on that bit of information asymetry. 

Much as the small investor conducts his own market sleuthing with the proverbial walk through the store, so do professional investors seek similar information advantages through channel checks across a broader number of businesses. Importantly, such presumed information disparity is what makes investment a worthy pursuit to begin with.

Sure enough, it is information asymmetry itself, not to mention differences of perception, that create the possibility of gain that lures investors to the stock markets in the first place. Happily, one man's optimistic vision of aggressive buyers inside stores full of consumers may very well be another investor's signal that the company in question is conducting a fire sale of sorts. It's this perception difference between bulls and bears that gives investors more broadly a reasoned view of the company in question.

Fischel points out that it wasn't until 1962 that the SEC "even asserted authority to regulate trading by corporate insiders possessing valuable information, and this view was not accepted by the courts until 1968." The SEC arguably stayed away from getting involved in what is said to be insider trading with good reason.

Indeed, those who might have the most accurate information about companies are company employees and executives, and there are certainly no laws on the books keeping them from buying or selling company shares. Instead, senior company executives, clearly trading with knowledge most likely not available to the public, report their holdings, and their sales/purchases are publicly reported, not to mention frequently listed in both print and online publications.

In that sense, the very notion of insider trading is somewhat of a misnomer. Be it employees of JP Morgan, Wal-Mart or Microsoft, those closest to the businesses are, as shareholders, presumably trading on knowledge not held by the general public. To ban insider trading would be to block the information provided by the very individuals most knowledgeable about the companies we invest in.

Also, not considered is the legal asymetry involved.  If a Google employee, or someone with inside knowledge of Google, chooses not to buy or sell the search firm's shares based on non-public knowledge, these individuals are in the clear.  Acting on "inside" information just as a buyer or seller might, that they're not transacting gives them a legal advantage over those that do. 

Reaping what we sow. Going back to the beginning of the new millennium, and in the aftermath of the Internet bust, there was a major crackdown on analysts in the employ of Wall Street firms. With their research seen as compromised by investment bankers eager to please the companies they served with good ratings, the natural result was that Wall Street firms reduced the size and scope of internal company analysis altogether. No longer able to enhance the investment-banking function of major banks, analysts became a cost as opposed to a source of profit, and they were no longer value-added in the way that they used to be.

Of course the de-emphasized role of analysts on Wall Street in no way reduced the desire of investors for useful information. New channels had to be found. This reality to a high degree explains the alleged insider trading scandals in the news today. Much as fish need water to survive, and politicians need money, investors can't exist profitably without information. Seeking to fill the information gap wrought by rules and regulations meant to solve yesterday's problems, "expert networks" sprung to life to fill the void left by analysts hamstrung by new rules.

These expert networks have become more prevalent in recent years, and their knowledge of the inner workings of publicly-traded companies has proven valuable to investors. The latter have found ways to pay for this nonpublic information.

What's not been asked enough is why we should be surprised by this development. Investors, and institutional investors in particular, must achieve credible returns in order to stay in business. Acting in their logical and rational self interest, they've paid for an information edge. Some would view this in a sinister light on the way to charges of insider trading, but saner minds might acknowledge that the pursuit of quality information is merely a good business practice. It should not be considered scandalous.

What about the small investor? Going back to the notion of information asymmetry, it is said that those in possession of nonpublic information - usually large mutual funds and hedge funds - achieve an information edge that works against the small investor. Allegedly, the small investor might exit the stock markets altogether if markets are rigged in favor of the large and informed.

The obvious problem with this assumption is that mutual funds largely serve the small investor that insider trading critics want to protect. In securing useful information, large institutional investors are almost by definition passing on the benefits to the "little guy."

And while hedge funds do not serve the little guy, they do seek investment capital from pension funds and other large investment entities that do. Ultimately the biggest and best are seeking return-enhancing information that accrues to the interests of those without direct access to it, or those who can't afford to exploit what they know.

Secondly, it's not yet been explained how a ban on nonpublic information helps the small investors who pick stocks for themselves. For one, it's fair to assume that many small investors are individual shareholders of public companies, and the sooner good news is priced into shares, the better off they are. This is particularly true if they intend to sell by a certain date in order to fund their retirement or education needs.

Similarly, assuming the existence of unfortunate information that is nonpublic, it's not explained how the small investor is advantaged when purchasing shares of a company whose stock price does not reflect the bad news. Better it seems to allow all good and bad information to reach company shares quickly so that the small investor can make as reasoned a judgment as possible when it comes to buying or selling.

Insider trading is an economic plus. Arguably the greatest reason that governments should encourage insider trading has to do with economic growth. To put it very simply, we live in a world of limited capital, and insider trading ensures that share prices will reach fully informed levels as quickly as possible.

To encourage the opposite, as in making insider trading a crime, is to delay the happy process whereby companies achieve a fair price. To the extent that market altering information is kept from reaching the marketplace, companies doing what investors want will necessarily not receive as much capital as they otherwise might. Poorly run companies will receive more capital than they can efficiently use.

The end result of either scenario is that capital is wasted, diverted, or destroyed. The better policy is to encourage market sleuthing and information edges that ensure the most efficient allocation of investment.

Conclusion. Even assuming the unlikely, that governments and courts could ever successfully define what is vague, it seems the act of defining the use of nonpublic information with criminal penalties in mind would be a waste of time. Insider trading, despite media-driven efforts to demonize it going back to the 1980s, is a good thing.

Indeed, to ban insider trading is to block the flow of information, and that ensures poorly priced markets that logic tells us would repel, rather than attract, investors. Ultimately investors need quality information to inform their decisions. To criminalize their pursuit of information which leads to better pricing is not just anti-capital formation, it also retards growth.