In other words, trading based on private information might benefit investors, as it stimulates a quicker absorption of new information into the markets, making them more efficient.
It is clear that insider trading continues despite vigorous enforcement of the existing regulations. This is because of the difficulties in detecting and prosecuting it. Further regulations will only add unnecessary complexity to market participants and eventually bind the already limited resources of enforcement agencies, which could be used more usefully. (Letters to the editor, 2007)
This novel (and presumably accurate) information will be beneficial because, these economists argue, markets are most efficient when there is the highest possible amount of information in circulation. The majority of economists, however, believe that insider trading is detrimental to the most efficient functioning of the marketplace -- as well as being detrimental to the most ethical functioning of the market.
Analysis and Discussion
Money, we are frequently reminded, is the root of all evil. That's certainly an exaggeration: Money can inspire people to act well, and certainly there are other sources of evil. But the lure of money can indeed lead people down dark psychological and cultural pathways, and one of the surest ways in which people can be diverted from such pathways is through sanctions. Regulations and laws against insider trading, as currently in place in the United States today, reduce the incentive of people to profit from particular types of knowledge when there is a social consensus that such actions are essentially unfair (Smith, 1997, p. 74).
While there are a number of studies that have demonstrated that insider trading reduces the profitability of financial markets at least to some extent over a period of time, this fact is not the most important reason that insider trading is wrong. Insider trading is illegal, and -- in a broader sense -- is a form of cheating. Anyone who has ever been the victim of cheating understands the anger that such victimhood brings, and understands how hard it is to regain trust in a situation or person who has done the cheating.
Preston and Post's model of corporate citizenship offers another lens through which to address the effects of insider trading. Their model posits that at the highest level of organization companies do concern themselves with corporate citizenship. Marsden (2000) defined corporate citizenship as a concern on the part of company leaders about the effect of the company's actions on the whole of society. A company that is indeed concerned with its corporate citizenship will be especially severe about penalties to individuals who engage in insider trading because -- even when such trading does not adversely affect the company itself, insider trading does cause damage to the market as a whole.
One important aspect of any analysis of the effects of insider trading must be a stakeholder analysis, because the (potential) risks and rewards of insider trading vary significantly among different stakeholder groups. Part of this differential arises from the differential risks faced by different stakeholder groups, but even more important in terms of assessing how significantly different types of stakeholders will be affected is the degree of moral peril that they believe that they will be exposed to because of such actions.
Jones (1991) argues that a range of activities and the actions that individuals are likely to make in those circumstances can be analyzed by the "moral intensity" of the situation for those individuals. The more intensely an individual feels that the situation contains a moral element, the more likely it will be that that individual considers the moral context and moral consequences of the moral elements of the situation when deciding how to act.
Different actions involved in insider trading have moral intensity, although they center on acting on information in an improper way, that is, making a profit in a way that harms others directly or indirectly. How likely one is to do this is affected by personality types, experience with the company as well as in the business world as a whole, how much authority and power one has in an organization, and larger issues such as cultural and social values in the realm outside of the boardroom (Loe, Ferrell, & Mansfield, 2000).
Carroll argues that ethics screening instruments must be designed both to filter out unethical behavior and to filter in ethical behavior, and that both of these types of filters can be analyzed in three different dimensions. The first of these is Utilitarian, which argues that the chief element of ethical action is its usefulness. This is obviously a very problematic standard, since what may be useful for an individual or an individual company may well be very problematic for the market as a whole.
The second of these dimensions is a justice perspective, which is simply whether an action is fair or not. Again, this is not as simple as it sounds because there is the additional question of fair to whom? How far does one have to extend the concept of fairness? The final perspective, that of rights, is simpler, because it can be addressed by the question of legality. Insider trading is illegal, and thus by the relatively narrow rights perspective is wrong.
Insider trading makes people in business mistrust each other because it puts short shrift to the idea that honest effort is what is takes to succeed in business. This trumps the real, measurable damage that insiders do to the markets, as summarized in this analysis, although this author discounts the measureable damage done to the market by insider trades in comparison with other analyses of this issue. (Lakonishok & Lee, 2001).
Insider trading does not appear to have any appreciable effect on the markets, at least as measured by the volume of trading that occurs. The Justice Department's last witness presented evidence showing that Mr. Rajaratnam made approximately $63 million in profits or losses avoided from his trading over the course of four years in a dozen stocks. Given that billions of shares trade on a daily basis, it is hard to imagine that these trades had much impact on the markets.
The companies whose information was taken have a stronger claim to being victims of the fraud because it is their own information that is stolen and used for personal gain by someone else. While that might support a charge of mail or wire fraud against those who orchestrated the improper disclosure, it is more difficult to see how the company is a victim of securities fraud when it is the shareholders who are actually involved in the trading, not the corporate entity.
There is also the argument that insider trading is simply unfair when a corporate insider or outside adviser takes advantage of access to information to reap significant personal gains that are unavailable to other investors. Steven M. Bainbridge points out in his book "Insider Trading" that "given the draconian penalties associated with insider trading, however, vague and poorly articulated notions of fairness surely provide an insufficient justification for the prohibition."
Perhaps the strongest argument about why insider trading is wrong is the simplest: because it is. While there is no clear definition of what "material" information is, there is no question that it is against the law and will be prosecuted if discovered. (Henning, 2011)
The degree to which insider trading harms the marketplace is probably impossible ever to determine, in no small part because the effects of insider trading are not uniform from one instance to another, but vary proportionately with a range of circumstances, including the type of information being acted on, the type of security involved, the size of the company, and the overall health and stability of the financial market sector and indeed of the entire economy at the time when the action occurred.
However, while it is difficult indeed to assign a specific monetary cost to the effects of insider trading, it is nevertheless agreed by most analysts to be detrimental to the fair, ethical, and efficient workings of the marketplace.
Insider trading is illegal. In the broadest sense, this simply means that we as a society have decided that insider trading is ethically wrong. As with other actions that societies decree to be ethically wrong, this means that we as a society agree that insider trading causes harm. So who is being harmed? The answer to this depends (again) on the specifics of the case as well as on one's concept of how the marketplace works. Investors are generally held to be among those most likely to be harmed by insider trading, and this is probably true on the most explicit level.
However, when marketplaces become skewed to benefit those who already are most likely to have more power and more wealth (for these are the individuals who are most likely to have access to insider information), then…