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Big surprise that I am in the camp who would argue no. What’s my major defense? Aside from the common argument that trading on inside information would seem to make markets “more efficient,” there is quite another approach to this.

The opposition to insider trading believes claims that when I as an insider trade on information that is not publicly available, I am committing fraud. How so? Well, the other party to a transaction must, by definition, have less information that I do. But this is specious reasoning for two reasons.

First, it virtually every single transaction ever executed in human history, one side of the deal has more or better information than the party on the other side of the deal.  The guy I bought my Taylor guitar from knows much more about how it was made, and how it would sound after years of use than I did. The farmer who sold me those strawberries knew better than me how well they would hold up in a pie. The employer who hired me knew a lot more about the comfort of my office than I did at the time of the deal. And so on. Would we want to call it fraud any time there are information inequalities? Not only would that put a grinding halt to all human activity, it ignores the fact that there are many mechanisms which emerge to force people to reveal this information, or to at least not gain unfairly by having it.

But that is not the major reason I don’t worry about insider trading. The most important thing about insider trading (or any trade in a reasonably competitive market) is that the other party to the transaction was going to engage in it anyway. Suppose for example that I am an investment banker, and I learned that Kansas City Southern Railroad planned on spinning off Janus mutual funds, and that this would generate a massive amount of profit for the railroad. Now, I go into the market to buy some KSRR shares. Does my entry into the market affect the decision of others to sell me those shares? Not at all. They were going to sell them no matter what. In fact, my entry into the market would have a slight positive increase in the price of the stock – benefiting those who would otherwise have sold for a slightly lower price.

When I have insider information and then trade on it, who exactly is defrauded? The seller of KSRR was going to sell anyway, and if they did not sell to me, they would have sold to someone else … and at a lower price. There’s more to the story of course, but we’ll leave that for another day.

One Response to “Should Insider Traders Be Punished?”

  1. Harry says:

    I understand your point, but I think it would be wrong if someone in accounting bought or sold before the press release of the good or bad news.

    That is not to imply that investment experts such as I would ever be able to react when, for example, J&J misses it’s forecast of quarterly earnings per share by a penny and the price per share dives.

    Nor would I be able to move the market even if I traded on what I thought was the very best inside information.

    What concerns me more is the unpredictability of congress, and the members’ lack of skin in the game. I wish Henry Waxman owned a million I Shares of the S&P 500. Or, I wish he realized that his state (California, not his existential state) is crumbling.

    I am more worried about those insiders. And you make a cogent point.

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