What’s the problem with insider trading?
Insider trading--the illegal selling and/or buying of stock based on inside information--has been at the center of many Wall Street scandals over the years. What's really wrong with this practice? It isn't that insiders trade stock, but that they have access to information which most people don't have, and that the information gives them an unfair advantage. Rather than simply banning trading on inside information, why not legalize it, and use insider trading to improve the flow of information to the market?
Okay, I'll admit this is a pretty radical notion. After all, insider trading has been illegal since the Great Depression, and nobody seems to be too enthusiastic about giving corporate executives an unfair advantage when trading their own stock. The problem is that insider trading continues, despite vigorous enforcement of the existing laws, because the temptation to use inside information to make a quick profit is so great.
Right now, the laws governing insider trading are "information based," that is, they are based on who got what information from whom and when. Trading stock when you know certain kinds of information is prohibited, but is permitted if you don't know that information.
I propose moving to an "insider based" set of regulations, that is, regulations which require handling trades differently based on who is trading, rather than what the person knows. Rather than ban insider trading completely, this would regulate it in such a way as to improve the overall efficiency of the market, and make enforcement of the rules simpler.
"Insider based" regulations would have the following elements:
Trading on inside information is legal. Anyone can trade any stock at any time for any reason.
HOWEVER, and this is the important point, stock trades placed by insiders do not go through ordinary trading channels. Rather, they get marked in the computers as "insider trades" and must be executed manually.
Here's how step 2 would work in practice:
Any trade made by an employee, officer, director, or privileged professional (accountant, lawyer, investment banker, etc.) of a company is entered into the trading system with a special flag which shows on the screens of the market makers. Unlike with a normal trade, no market maker or specialist is obligated to take the other half of the trade, or provide the prevailing market price. Distinct flags would be assigned to the different classes of insiders (i.e. E for Employee, O for Officer, D for Director, P for a privileged Professional), since these classes are assumed to have different access to inside information.
Since it is presumed that an insider will have information not available to the public, market makers would generally give the insiders a worse price than the general public gets. Just as importantly, market participants would have the ability to react to the pattern of insider trading, since the pattern would be visible in real-time as the trades are placed.
If a single insider trade appears which isn't unusually large, it would probably get close to the market price. But if a lot of trades started appearing, market players would quickly realize that something was going on. The stock price would change quickly, eliminating the advantage of the inside information, and allowing the stock market to reflect the true value of the company.
For example, if a lot of buying by "O" and "D" class insiders started appearing, market participants might assume that there was good news, such as an acquisition, in the works. The stock price would quickly adjust to reflect this information, and any advantage to be gained through what is currently illegal insider trading would be negated. As a result, it wouldn't matter if you tipped off Martha Stewart. The market price would already reflect the unannounced news.
Or, if "E" class insiders started selling at the same time "O" insiders were buying or doing nothing, that could be a clue that sales forecasts are unrealistic and management is clueless. This provides an insight into a company's performance which simply isn't available today.
The other advantage to this regulated form of insider trading is that the rules would be much easier to enforce. Right now, prosecuting someone for illegal insider trading is a complicated affair, requiring the prosecutor to prove who knew what when. Under "insider based" rules, it becomes a simple administrative task: was the trade properly designated as an insider trade or not? What the insider knew becomes irrelevant.
So, by moving from "information based" insider trading rules to "insider based" rules, we can both make the market more efficient, and improve the enforcement of the rules. The only losers would be the people who currently trade illegally and haven't been caught yet.