Steven Cohen Is Not a Reason to Allow Insider Trading
(Corrects fifth paragraph to indicate how investors possessing insider information value a security.)
With investment manager Steven A. Cohen charged with five counts of fraud, Dylan Matthews of the Washington Post thinks the U.S. should have never banned insider trading in the first place.
It's not an outrageous view, in fact, and he raises some strong points. If insiders choose to hold their shares of stock on the basis of material nonpublic information, that's indeed as much a trade as actually buying or selling. Yet I think Matthews overstates a benefit he identifies (more efficient pricing) and overlooks costs that arise from asymmetric information among market participants. It's worth keeping the ban on the books.
Here's the problem: Institutional investors have too much cash and too broad a portfolio to be at the frontier of knowledge for every investment they make. If they can expect that all the other traders are working from public information, what's the right price for them to bid or ask for a security?
The answer is simple: its value to them, given the rest of their portfolios and how they balance risk and reward.
Insider trading changes that calculation. Insiders' willingness to buy or sell itself contains information. They must think the security is worth more than their bid, or less than their ask. They wouldn't be trading otherwise. The outsiders now set bids and asks according to a different question: Given that insiders are willing to trade with them, what's the right price?
This is a point George Akerlof develops in a famous 1970 paper, "The Market for 'Lemons'" -- used cars of dubious quality. His work suggests that widespread insider trading would do three things: (1) reduce the value of investments as buyers demand a penalty against the risk of insider selling, (2) reduce market liquidity, and (3) raise bid-ask spreads.
One response to this argument is if a business didn't want insider trading of its stock, it could recreate insider-trading laws with contracts than ban employees and shareholders from acting on insider information.
Sadly, despite its libertarian streak, the rebuttal fails for three reasons. Incentives can be misaligned so that even if insider trading is good for the business who could ban it, it could be bad for markets overall. Next, executives' boardroom influence would likely shield them from prosecution. And, lastly, the state already finds insider-trading rules hard to enforce, so for a private contract, enforcement will be almost impossible and the risk of punishment next to zero.
Matthews also says that insider trading could have saved markets from the losses inflicted by the Enron collapse. If only we allowed insiders to dump the stock, he writes, then the world have known something was wrong a lot sooner. Insider trading puts information into the market -- and, Akerlof notwithstanding, that's good.
This misses a perverse incentive: Insider trading discourages whistleblowing. An orderly legal action would surely be a better response to malfeasance than "silence the whistle, let's go make some dough."
This point is damning in a more general way. Matthews says that insider trading makes markets more efficient by incorporating information more rapidly into prices. Yet insider trading also gives investors an incentive to conceal information to extract rents. So much for efficiency.
(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)