Decriminalize Insider Trading

One of the mortal sins that keeps financial regulators up at night, gnashing their teeth and screaming into the darkness, is insider trading. The SEC defines this wretched practice as the abuse of material, nonpublic information in trading securities. The idea is that allowing market participants to trade on privileged information creates an information asymmetry (essentially that leveraging special information is unfair to the rest of us). However, is this really true, and is this information asymmetry as much of a problem as we are led to believe? Today I want to continue my string of contrarian arguments by arguing that we should reconsider our hatred towards insider trading. I am going to show that insider trading is no worse than current market practices and that its legalization will not significantly alter the quality of the stock exchange.

Existing Information Asymmetries Are Huge

The first thing that needs to be highlighted about the modern market is that various participants already have obscenely privileged information relative to an average trader. The stock market allows both amateurs and professionals, and every grade in between, to trade the same shares and to take opposing positions. When you trade Tesla shares on Robinhood, you are not trading against Joe Schmoe. You are trading against Ken Griffin, founder and God Emperor of Citadel, with billions of dollars and thousands of employees at his disposal. For example, this is the setup on the other end of your trade:

Thousands of screens focused on zeroing you out

The information asymmetry between you as an amateur and a professional hedge fund is almost inconceivable. Consider what it takes to accurately price a stock: experience in the industry, an understanding of the company's financials, a thesis about the future, and research to justify this thesis. Professional traders have decades of experience and infinitely more man-hours to throw at the problem of fairly pricing a stock than you do. These professionals can also pay for access to information that a regular person simply cannot afford. For example, it’s common for firms on Wall Street to pay up to $1,000 per hour for phone consultations with industry experts, with investors often scheduling dozens of these calls per deal or trade they make. Wall street today is also equipped with superweapons like the Bloomberg Terminal and Blackrock's Aladin - proprietary tools that can synthesize information faster than a human analyst. A regular person has access to none of these levers and cannot pay the tens of thousands of dollars that they cost per trade. So the playing field was never really fair for the retail trader.

Smarter Than A CEO

In fact, due to the power of these Wall Street tools, an argument can be made that hedge funds know the medium or long term direction of a stock even better than most company insiders. Wall street has several advantages in this respect, among them are access to more industry data (Bloomberg and other tools), laser focus, and a more impartial view. A typical corporate executive at a company like Target, for example, is focused on selling more groceries, not on analyzing page 156 of Target’s quarterly report looking for a crucial statistic with the scrutiny of a coked-up hedge fund analyst. Likewise, managers at most companies have an intimate knowledge of their own operation and a myopic focus on their own advantages, while knowing relatively little about where the competition is headed. The job of a corporate executive in many ways amounts to boasting about their company’s accomplishments (shilling their stock), which also creates a strong cognitive bias. It’s very difficult to lie for years on end about how great your company is without beginning to believe your own rhetoric. A wall street trader will generally take a more neutral view since they are incentivized to price the stock correctly, not to preach whatever will make it go up. So we have no reason to suspect that the information known by company executives is somehow a more powerful predictor of the long term success of a stock than the knowledge accessible to a wall street pro.

Timing Advantages

Of course, this argument overlooks the very concrete, short term timing advantage executives have over traders. For example, company executives typically know about a product launch in advance of its announcement and would be able to trade on this short term signal for a quick gain. But what if I told you that we already allow the existence of timing advantages in the market? Specifically, certain hedge funds known as High Frequency Trading firms will go to great lengths, like physically having an office closer to the NYSE, to pre-empt the trades of others by exploiting millisecond gaps in trading signals. If this timing advantage held by certain firms is fair game then why is a company executive trading on a project they know about in advance unacceptable? If you really think about it, in either case someone is making a trade based on information they have access to in advance. Why is one scenario acceptable and the other a crime?

It’s therefore evident that the advantage corporate executives have in terms of the breadth, quality, and even timing of information available to them is nothing out of the ordinary compared to our current stock market. Hedge funds already have an informational and timing advantage over you in their trades, yet no one is grabbing their pitchforks at this simple reality.

Scientific Consensus, History

All of this theory is interesting, but as a disciple of science, you may want to know what our top economists think. Surprisingly, there is no scientific consensus on whether insider trading is harmful to the economy. Many economists have argued either camp, including famously, Milton Friedman expressing support for decriminalization. Part of the reason the lack of consensus on this topic is so surprising is due to the draconian enforcement of insider trading laws by our governments, which routinely send people to jail over insider trading violations. While Wall Street suits may be some of the most unsympathetic victims imaginable, it is still rather strange that we send people to prison over something our best minds cannot agree is actually harmful. There is no other sphere of life where we accept a similar arrangement, where we insist on criminal punishment without a strong consensus that the crime has caused tangible harm.

Another curious fact to consider is that insider trading laws are a surprisingly recent invention (e.g. Japan only criminalized insider trading in 1988), meaning we have plenty of historical data on the performance of markets with legal insider trading. The historical verdict on the harmfulness of this practice also appears to be inconclusive. For example, Japan did not experience a material improvement in its stock market practices after banning insiders in 1988. In the USA, the SEC banned insider trading in 1934, after the market crash of 1929. Since then, market crashes have continued to regularly happen, so the initial idea of preventing future crises did not pan out. Critically, there were no other noticeable improvements around the quality of the stock exchange after 1934 that economists can attribute to the ban. There are plenty of other examples from history one can examine to the same effect.

Conclusion

After the dust has settled, we are left with a practice that is no worse than existing loopholes and has no scientific consensus or historical evidence of harm. The initially repulsive idea of insider trading is now cast in a much softer light. There appear to be no concrete objections to insider trading in terms of ethics. Economists can’t agree on a specific harm that it causes. Lastly, we’ve tried legal insider trading before with no apparent damage to the market. Why not reconsider sending people to prison over an idea with such weak foundations?