Insider Trading: Economic Effects, Ethics, and Market Trust

Introduction

Insider trading has two distinct effects on the financial sector. The first is a purely economic effect, while the second is an indirect effect that, though harder to measure, in all likelihood carries a more serious overall impact. The first effect is that insider trading (also known as "informed trading") reduces the liquidity of a marketplace or a market sector (Fishe & Robe, 2002). Liquidity can be understood largely as a function of the degree of informational asymmetry that exists in the marketplace. When the degree of asymmetry shifts because of insider trading, the liquidity of the market will almost necessarily shift as well.

The less measurable but potentially even more important effect of insider trading is that it breeds a level of distrust in the marketplace and in business in general that would not otherwise exist. Businesses — including especially the financial sector — rely on a certain level of trust in each other and from their customers. Without this trust, business cannot be conducted. The more illegal and unethical behavior there is, the less trust there is, which makes it difficult even for honest brokers to do business.

For people who do not actively participate in the financial markets — or who do so only indirectly, such as through their 401(k)s — the topic of insider trading might seem sufficiently distant and arcane to be irrelevant to ordinary financial life. However, even at a relatively low level, insider trading has a widespread effect on the financial sector, which in turn affects the rest of the business world — and therefore affects everyone who interacts with it, which is all of us.

There are, as noted above, both technical effects of insider trading — constituted primarily of reduced liquidity and the consequences that follow from it — and an overall reduction in the trust that people have in business and in businesses. This can have dire consequences, because economic activity depends in largest measure on trust. Certainly governmental regulations are important and helpful, but there can never be sufficient regulations and regulators to ensure that every businessperson is acting honestly.

Business, like other realms of human activity, cannot be conducted unless there is a basic degree of trust among the parties participating. No reasonable person believes that any activity involving a large number of individuals — especially one in which there is a great deal of money to be made — will be entirely free of unethical behavior. But while some unethical behavior is to be expected, its presence beyond a certain threshold is highly disruptive.

This paper examines the phenomenon of insider trading, establishing what it is, how widespread it may be, what attempts have been made to prevent it, and what consequences occur when it cannot be prevented. While illegal activities take place in all nations in terms of how business is conducted — for where there is money there will always be a certain amount of unethical behavior — this paper focuses solely on illegal behavior in the United States and the specific federal laws and regulations that make insider trading illegal.

Literature Review

Insider trading is the trading of a corporation's securities — including stock, bonds, and stock options — by individuals who have, or who may have, information about the company's financial health and especially about future changes in the company that may significantly affect the value of those securities. This does not mean that company "insiders" — including managers, members of boards of directors, major shareholders, and employees — cannot trade in the company's securities at all. The term is also used to describe the use of non-publicly available information by members of the public when that information has been passed on to them by someone with a direct relationship with the company.

Rather, federal law requires that when individuals possess information about a company that is not available to the general public, they must trade in a manner that is not based on that special knowledge — a tricky legal standard. When insiders do make legal trades regarding their own company, they must make those trades public knowledge within a few days of finalizing the transaction.

The legal background for the prohibition of insider trading stems from common law traditions — both English and Spanish common law, which have been incorporated into state law depending on geography and colonial history — as well as U.S. court decisions. At the root of both common law and judicial bases for the prohibition is the larger legal concept of fraud: the public is seen to be defrauded when certain traders possess an unfair advantage. While this is a clear enough standard and legal concept on one level, it remains complicated in practice, given that what constitutes insider knowledge that may lawfully serve as a basis for securities trading and what constitutes insider knowledge that may not can shade together into an amorphous gray zone (Ma & Sun, 1998).

The specific legal prohibitions against insider trading — as opposed to the broader legal issue of fraud, which is ancient — go back a century to the 1909 U.S. Supreme Court case Strong v. Repide, 213 U.S. 419. The case involved the sale of land that benefited individuals who possessed specific "insider" knowledge about the future value of that land. (The word "insider" carried no legal meaning at the time.)

The Court noted in its conclusion the key distinction between information that was publicly available and information held only by insiders, even if that information might have been suspected by the public:

"It is undeniable that, during all this time, the subject of the sale of the friar lands was frequently mooted and its probabilities publicly discussed in a general way. Such discussion was founded upon rumors and gossip as to the condition of the negotiations. The public press referred to it not infrequently, but the actual state of the negotiations, the actual probabilities of the sale being consummated, and the particular position of power and influence which the defendant occupied in such negotiations prior to the time of the purchase of plaintiff's stock were not accurately known by plaintiff's agent or by anyone else outside those interested in the matter as negotiators." (U.S. 427)

While the nature of securities trading has become vastly more complex in the intervening century, the basic legal and ethical principles have not changed (Harris, 2003, p. 593).

There is, in addition to the legal and ethical arguments, an economic argument to be made regarding how insider trading affects market efficiency. There is an allied argument that the most efficient market is also the most just, in that a perfectly competitive market rewards talent and effort — qualities available to all — and is therefore the fairest.

According to this economic model, although perfect competition is rarely if ever achieved, its significant advantages make it a goal worth striving for. Actions that move the market closer to perfect competition should be encouraged; actions that move it further away should be discouraged.

Insider trading, with its inherently unequal distribution of information, clearly runs counter to perfect competition. The preferred outcome, according to this economic model, is that inside information be made publicly available so that all market participants have access to it. Barring that, all market participants should have access to the same information. Thus, insider trading is impermissible in a perfectly competitive economic model (Sayler, n.d.). The degree to which one finds this a reasonable model depends largely on one's broader beliefs about how markets function.

It should be noted that some economists believe that insider trading is at worst a victimless financial crime and can arguably be viewed as beneficial to financial markets. This group — primarily Milton Friedman and fellow travelers such as Thomas Sowell and Henry Manne — argue that insider trading is generally beneficial because insiders possess the newest information about a company. This economic argument is summarized in the following letter to The Economist:

"Amid the increasing frequency of insider trading phenomena, an alternative approach should be considered. Rather than simply forbidding trading on insider information, why not legalise this so-called 'market abuse', and use it to improve the flow of information to the market? As mentioned in the article, the Nobel Prize-winning economist Milton Friedman himself noted that 'You want more insider trading, not less.' Friedman argued that it will give people most likely to have knowledge about deficiencies of the company an incentive to make such deficiencies known. 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 information, these economists argue, benefits markets because markets are most efficient when the highest possible amount of information is in circulation. The majority of economists, however, believe that insider trading is detrimental to both the efficient and the ethical functioning of the marketplace.

Conclusion

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 agree as a society that insider trading causes harm. So who is being harmed? The answer depends 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 at the most explicit level.