Comment by jvm | Hacker News Reader

Comment by jvm | Hacker News Reader

Insider trading seems unfair. But after a lot of thinking and listening to arguments on both sides, I now actually find the argument in favor of legalizing insider trading fairly compelling. I'd suggest that anybody with strong feelings against it take a little time to consider the arguments for.

The argument for has two levels:

1) The trade is a victimless crime. Given the way markets worse, the naïve party would have bought or sold the asset anyway from someone else. Think about how you buy stocks: you just call your broker and ask to buy at the market price. If you do that and end up buying from an insider, you are no worse off.

2) Insiders actually move the price in favor of the naïve party they trade with. If a stock is being sold on the market $29 and the insider knows its true value is $20, they must sell below the other offers (e.g., $28.99) to make the trade. This is in favor of the buying party relative to the outcome without the insider: the buyer will lose $.01 less per share. At large trading volumes, insiders will actually move the market strongly in the direction of the fair price, making all trades of that asset more fair.

Unfair though it may be, society at large does not benefit banning insider trading, and allowing it would make stock market prices more accurate which is actually probably a fairly strong benefit to society.

I have a PhD in economics, and I was initially convinced by these arguments, but the are actually misleading.

If I have inside information, and there is a market with 1000 people, and I make $100 by doing insider trading, that money must come from the pockets of those 1000 people. This follows from the fact that the stock market is (for these purposes) a zero sum game.

The error in your argument is that (1) is false. You say "you just call your broker and ask to buy at the market price". But if every market participant was like that, then the order books wouldn't match and the market would break down. There must be some participants who are price elastic. And these are precisely the people whose decisions are effected on the margin, that is, the people who you cause to buy/sell when you engage in insider trading.

So when I buy shares with inside information (say I know the price will rise), I cause the price to rise by a tiny amount, and induce some people to sell who wouldn't have. Since these people wouldn't otherwise have sold, they lose money from my actions.

It is true that insider trading provides information to the market place, and so it is beneficial in that sense. However, it also creates asymmetric information and so harms liquidity. While there is always asymmetric information (I own stocks through my 401k, but I have no idea what MSFT should be worth), insider information is an especially extreme kind, and therefore especially harmful to liquidity.

The victim is trust in the market. If you know that someone else may have better information than you do, you get a "market for lemmings" situation where everybody assumes that the only reason someone would sell a stock is that they know it's going to tank, and so nobody buys. Liquidity collapses, and with it, the market.

The SEC isn't intended to protect individual investors, it's intended to protect the market as a whole. That's why they don't care when individual people get screwed, only when people get screwed to an extent that they won't invest in the market. People change their behavior based on what other people do; without full public information, the result of that tendency is to tend towards zero liquidity.

forgive me if I don't shed any tears for 'trust in the market'. Shouldn't we be more suspicious about the market? People blindly throw their money at the hands of fund managers etc, which means our society is overleveraged on risky propositions.

There's a lot wrong with the financial markets today, but I'm pretty certain life would be significantly worse if they didn't function at all. I don't think that most people realize the extent that our modern, industrialized, highly complex society depends upon efficient capital markets.

You can order a TV off Amazon and have it shipped to your doorstep tomorrow. That TV was probably assembled in Taiwan from parts made in China and Vietnam, shipped across the Pacific, loaded onto a trailer, sent to an Amazon warehouse, FedEx'd in a jet plane and driven to your house. The majority of firms in that value chain are public companies; what they do is capital intensive. Without functioning capital markets that money would've been used to buy up city real estate and drive up rents.

The trade is a victimless crime.

Like punching someone in the dark!

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