Insider Trading is Stealing

Over at econlib, Charles Hooper argues that insider trading doesn’t really hurt anyone. Insider trading instead is a victimless crime, and is in fact beneficial.

His argument goes like the following:

In the market for any given stock, there are “uninformed buyers” and “uniformed sellers.” That is, people who buy and sell stock but without inside information. In his example he uses the case of something very good happening to a company soon. The number of uninformed buyers (or technically the shares which uniformed buyers buy) will equal the number of uniformed sellers (with the same technicality).

The uniformed seller is hurt because he does not reap the rewards of the good news, but remember this is before any insider trading occurs, so it can’t be said he is hurt by insider trading.

Then, and insider comes along, buys a number of shares, and profits from the good news, making a large sum of money after the news is made public. Mr. Hooper asks who is hurt from this? Certainly not the uniformed seller, because he was going to sell anyway. The person most hurt is the uniformed buyer, who loses on the opportunity. Yet the uniformed buyer has no real claim to the potential benefits, after all, the buyers can’t complain that the “Insider snatched Uninformed Buyer’s dumb-luck windfall”.

There is one fatal flaw in the argument: Mr. Hooper seems to believe that any increase in the number of buyers will be offset by an equal decrease in buyers. But there are two ways that an increase in buys can effect the market, it can “crowd out” other buyers, or it can cause more people to sell, most likely some mix of the two. For various reasons, I think that the effect would be more sellers rather than fewer other buyers, but all we need to establish is that some of the effect of buying shares is encouraging others to sell them.

Now, we see the problem. The insider, an employee and agent of the shareholder, is transacting with the shareholder, using the knowledge that they gained only through being an employee against the shareholder. That is simply wrong.

Let’s clarify with an example: lets say that three friends pool their money to form an oil exploration company, hoping to find the next big well. One of them runs the company (being an engineer and all), and gets paid a salary, but the three friends split all profits evenly. They go a long time without finding any oil, and all three are discouraged. Then, one day, it becomes very evident that they are about to strike oil; but only to the one running the company. Instead of telling his co-investors about it, he instead offers to buy up their shares.

We can argue about ethics and why this is or isn’t ethical; but those discussions go nowhere. Instead, lets talk about economics. Each outside investor knows that, whenever they transact with insider, they can expect to lose. If they sell their shares to the insider, well they can bet that they’re on the verge of hitting oil. And if the insider offers to sell his shares, then they can be certain that the wells are dry (or that the expected find won’t pan out). Basically, the outsiders have one rule if they don’t want to get screwed: never transact with the insider. This of course hurts the insider, why shouldn’t he be allowed to sell to his co-investors if he needs the money, or buy if he has a windfall he wants to invest? In fact, we can see that the insider is worse off in this example than the outsiders (assuming they have jobs which pay the same), they can transact with each other (buying to invest, selling shares in order to consume), assuming their counterpart wants to do the opposite. But the insider can never transact, nobody will every buy from him or sell to him.

How do we fix this? Simple, make it a law that says that the insider can’t transact based on knowledge that he has that the outsiders don’t; the outsiders will now be willing to sell, knowing that they are protected if the insider has material nonpublic information. Thus, the insider now has the same privileges as the outsiders, and (in our simplified example), everybody is better off (they all have more potential trading partners) and nobody is worse off – clearly a pareto improvement.

But lets imagine a twist to the scenario. Instead of buying the shares directly from the outsiders, the insider sets up a shell company to purchase the shares from the outsiders, the outsiders have no way of knowing that the company is really owned by the insider. Is this ethical? I certainly don’t think so, all the shareholders put their trust in the insider that he would act in their best interests; keeping all potential upside is certainly not within their interests.

Lets use a third example. Same company, same three friends. They strike oil in a well which is expected to produce 100 barrels a day. Instead, it produces 120 barrels a day. The insider decides to take the extra 20 barrels and sell them himself (whether he does this buy selling them through the company and then embezzling the money or physically diverting the 20 barrels a day is unimportant). Is this action ethical? No – it is stealing. But it’s really the same action as above – using insider information (in this case the number of barrels being produced) in a manner against the best interests of the shareholder. How is this any different from insider trading – finding the extra 20 barrels a day, and then offering a price to the other shareholders based off of 100 barrels a day. In fact, it can be shown that the economic impact is exactly the same- the outsiders get the net present value of the sale of 100 bpd split evenly while the insider gets the net present value of the 20 bpd entirely to himself.

Now, you may argue that this doesn’t apply to the situation of the market as a whole; after all transactions on the stock market are much more anonymous. But this doesn’t make it better, it makes it worse. There is (typically) no way of knowing who you are buying shares from; so the insider who buys shares using material nonpublic information would be as if the insider in our above example set up a shell company to buy shares from the other investors. They would sell without ever even knowing that they were selling to the business partner. I can’t see how any of this is ethical, it is currently illegal and should remain so.

Leave a comment

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: