It's time to legalize insider trading
|June 17th, 2014, 11:09 PM||#1 (permalink)|
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It's time to legalize insider trading
M&A is on fire again, and according to a new study from professors at the Stern School of Business at NYU and McGill University, so is insider trading. The study says that up to a quarter of all M&A deals may foster some level of insider trading.
As insider trading is clearly already pervasive, and a significant use of time and resources, I think it's time to finally legalize insider trading.
That assertion sounds shocking and awful — how could anyone advocate for insider trading? I encourage you to read beyond the headline to think about the role of information, the lack of victims and the actual analysis of what trading on non-public information means.
For clarification, I am speaking purely about the legality of trading on insider information. I do believe strongly that those with access to information should ethically and morally respect any confidentiality agreements and fiduciary duties with the companies from where they are accessing the information, but that is a separate civil, not a criminal, matter.
A crime with no victims. The crux of most insider-trading-as-a-crime arguments is that insider trading creates an uneven playing field and the laws protect the average investor. I disagree. How do you have a crime when there is no victim? Your decision to make a trade in the market isn't predicated upon who is on the other side of the trade as either a buyer or a seller. Just because one side profits (or avoids losses) that does not have a direct impact on the counter-party. Why prosecute a crime when the other side doesn't get hurt?
Information efficiency benefits the average investor. Doing away with insider trading as a crime benefits all market participants. Information is the driver of market efficiency. While a perfectly efficient market will never be achieved, getting information to the market as quickly as possible helps to alleviate asymmetry and allow that information to reach a maximum of participants as quickly as possible. By encouraging people to seek out non-public information and bring that to market more quickly, you even out volatility, lessen the exposure to bad information and increase the exposure to good information, each of which benefits all market participants.
Profits to be made from information acts as an incentive, which helps expedite that flow of information. However, if insider trading were legal, you would have more participants seeking out that information, so not only would it get to market faster, it will lessen the reward and profits of those trading on it. That's a fancy way to say the big guys would actually make less money if you got rid of insider trading.
It's hard to separate proprietary research and insider information. While trading on an M&A deal, like the examples cited in the aforementioned study, are clear-cut cases of insider trading, many times the line is blurred between information and research. For example, if I sent a team to the mall to count traffic and interview customers outside of a store and noticed from that research that sales were up from previous months, that's technically non-public information. But that information is derived from research and trading on that research is legal. However, if I had dinner with the CEO of that same retailer and he told me that sales were up from month-to-month before he put out a press release, that would still be non-public information but it would be illegal to trade on it. It's the same information, so should the methodology of retrieving it make a difference? No, the market doesn't care how the information was obtained, it only cares that sales are up.
There's selective enforcement. The Stern/McGill professors' study shows that the SEC only investigates a small portion of the deals where the study found suspicious trading activity. But that's not the only type of non-enforcement of insider trading. If someone receives insider information, you may be able to prove when they acted on a piece of information, but you can almost never prove when they don't act. If I was planning to sell a stock, but received information that things were going really well and don't sell because of it, that's no different than buying for the same reason, except that you can prove the latter. The same thing goes for not buying something you were planning to buy but heard unfavorable information.
Not to mention the recent activities of hedge-fund managers like Bill Ackman, who build a position in a stock ahead of announcing their involvement in a takeover bid for that company (such as was the case in his recent Allergan bid). That's legal, so why have a law that only applies in some cases?
I take issue with making something illegal when half of the outcomes are unenforceable.
Insider information doesn't guarantee outcomes. There are many instances where even if you had perfect information, you wouldn't know how the market would react to that information. A merger announcement may make a stock go up, but sometimes it bafflingly moves in the other direction. Even a positive sales announcement may not move a stock if that expectation was already priced in or forward guidance is week. Trading on insider information gives you some information, but without another critical piece- how will other market participants react.
In the markets, as in life, someone always has an advantage. There are participants who have faster computers. There are participants with better algorithms and smarter staffs. There are those that transact a lot of business with certain investment banks who are going to get more favorable allocations in IPOs because they are more active clients. Someone is always going to have an edge somewhere.
If you don't have the best resources, as an average investor, you still would have some level of disadvantages. But remember, most average investors don't invest solely by themselves. They participate in mutual funds and pension funds, which do have access to larger monetary resources and who invest in firms with such access as well. So, when a bigger player benefits, endowments, pension funds and retirement plans also benefit. In fact, the big guys thrive on information asymmetry, so eliminating insider trading restrictions would likely be at the expense of those major market players.
The bottom line is that, despite the spin of the headlines, trading on non-public information has no victims and frankly creates the best outcomes for all participants by smoothing volatility and creating more accurate pricing. Instead of wasting time and resources on prosecuting it, we should be devoting time and resources to legalizing it.
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