Should we legalize insider trading?

10/16/2015 08:14:00 AM
This is a question I was debating recently. I think the answer is no.

There are a few reasons to be skeptical of the insider trading ban. It doesn't really create that much of a consumer protection as we typically think of the term--the idea that ordinary 401k investors can compete with hedge fund managers if only we could eliminate insider trading is completely absurd. And besides, for the most part stock trading is rich guys ripping off other rich guys, so the public policy impact of the insider trading ban is a lot less than what people commonly assume.

But there's a weird talking point that says that insider trading is a victimless crime. Here's John Carney saying exactly that in his debate with Matt Yglesias. He's wrong.

I think it's helpful to think about this in terms of the peanut-butter parable.You may have heard of Michael Parnell, the executive of Peanut Corporation of America who was sentenced to 17 years of prison for ordering his company to ship orders of peanut butter after tests came back positive for listeria, a dangerous bacteria. The company went bankrupt, obviously. But while Parnell was just downright evil, even companies that do everything right occasionally have serious recalls. A number of years back Proctor and Gamble also had a contamination issue in their Jif brand peanut butter. They handled it properly and issued a recall--it is safe to eat P&G products--but the massive recall nevertheless burned a hole in their ledgers and it took a long time for P&G stocks to recover.

What if, as a peanut butter executive and stock owner, you had just seen a not-yet-public positive test result for listeria? You could sell your shares right away and then make the result public. That means someone has bought shares from you at the pre-recall price, even though you knew the price was about to collapse. That is, you took their money and then destroyed their assets.

I don't really think anyone can argue that this isn't stealing.

The fallacy that commentators often make is forgetting that there's a counter party in every transaction. You don't just sell stocks to the ether, you can only sell if someone buys. When you sell you take someone else's money from them. When you do that under false pretenses--such as pretending there's no massive listeria-induced recall--you are stealing. Insider trading bans don't level the playing field, but they do force companies to take the fall for their own screw ups, and I think that's a good policy.
Max 10/16/2015 04:20:00 PM
Think of the stock market as a casino (which it kind of is, among other things). Insider trading is cheating the house, the house in this case being market makers or anyone who supplies liquidity to the market.