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You may have heard this topic before. Such-and-such “regulator” (whatever that may mean) has launched an investigation to determine if Mr (insert your favourite name here) has been involved in so-called “insider trading”. Sometime you may hear that that this person will be placed on trial and sometimes even go to jail for his “crime”.

We have to ask: what crime?

INSIDER TRADING

What is insider trading? It occurs when a person with so-called “privileged” information buys or sells shares and profits from the transaction. This “privileged” information is usually some sort of insiders-only info, this is, information that only key people belonging to a publicly traded company may know. The information may be positive (the signing of a contract) or negative (really bad end-of-year profit numbers).

THE CRIME

Most legal systems deem insider trading as bad. We are told that the person with this specialized information is buying or selling stock and in so doing is creating a loss for the counter-part (this is, the other person selling or buying the stock respectively). This would seem to be somehow unfair, or worse, un-ethical (whatever it may mean). In order to prevent this horrible, horrible crime, all kinds of rules and regulations have been put in place. Many deal with the do’s and don’ts of the transactions themselves and many deal with public notification of these transactions. These processes are supposed to make such transactions “fair”.

THE JUSTIFICATION

Let’s backup a little and try to understand this logic.

Case A: A person has come across a piece of information which he/she believes can generate a profit. This information is proprietary to the firm. This person proceeds to act on this information by buying or selling shares and somehow this is evil and illegal.

Case B: A sophisticated trading firm hires a meteorologist to forecast the weather and hence provide advanced information of crop growth. This information is proprietary to the firm. Traders in the firm proceed to act on this information by buying or selling commodity contracts to make a profit. This is not evil and it is perfectly legal.

In Case A and B we are dealing with proprietary information. In each case there were counter-parties to each transaction. In both cases these counterparties lost money. We are confused, where exactly is the difference? Guess what? There isn’t one.

THE REALITY

Legal justifications make it appear as if insider trading is a risk-free operation. That it is simply a scam. That somebody is stealing from unsuspected victims. This is far, far from the truth. Let’s review a few facts.

Fact. Insider trading is not risk-free. The trader must not only get the information right, but must also get the timing right. It is true that, in general terms, the trader trades with less risk than the counter-party, but so what? Where exactly does it say that in every single transaction risks must be equalized? This may be news for regulators, but in a marketplace risks are never equal. That’s the whole point of price discovery. To reach a point at which both would-be actors in the transaction perceive that their risks and rewards are at adequate levels. Emphasis on perceive and adequate levels.

Fact. The counter-party to an insider trading transaction is not doing it for charity. The counter-party believes that he/she may have better information than the insider trader. The counter-party is trying to “scam” and “abuse” the insider trader as much as the insider trader is trying to “scam” and “abuse” the counter-party. Furthermore, this transaction is voluntary. The insider trader is not holding a gun to the counter-party while saying “the trade or your life”.

Fact. Each market transaction creates new information which is embedded in the price. Without insiders the market would be far less efficient. Consider this. Let’s assume a company is in bad financial shape and will go bankrupt. The company knows this, but it insists in signing contracts that it never intends to fulfil while demanding payment up front. Unsuspected client do just that and they lose money in the process. Why? Because they had no advanced warning the company is in troubles. However, if insiders begin to sell company stock like there is no tomorrow, potential clients will stay away from any contract, hence saving a lot of money.

Fact. In many countries and for many decades stock exchanges operated without any regard for insider trading. Most traders worked on the basis of “tips” or “recommendations” or some other type of restricted information. Some people lost money but other people made fortunes by investing with those traders. And guess what? The world did not come to an end and the Index of Evil did not rise a bit.

Fact. In many modern countries today, insider trading is in the law books but it is thoroughly ignored. And guess what? Exchanges work just fine!

THE SOLUTION

Many people believe that free markets could control this kind of “problems”. Some are of the opinion that Stock Exchange competition may impose different rules and through these rules people may choose to trade in insider-trading allowed or dis-allows Exchanges. They are mistaken.

The concept that somehow Stock Exchanges will police these transactions is ridiculous. There are thousands upon thousands transactions that happen every minute or even every second. Launching an insider trading investigation is extremely time consuming, expensive, complicated and ultimately pointless. It is highly improbable that anything could be proven.

So what solution would a free market offer? The free market offers a no-solution. Allow us to explain.

The goal of an average company during an IPO (initial public offer) is to get the maximum capital possible; this means maximum share price. Will this company be concerned about insider triaging? Most certainly not. The market is difficult enough even without considering insider trading. This company will be looking for bid volume, not transparency. Therefore they will chose the Stock Exchange most likely to generate them the maximum price, irrespective of insider trading considerations.

And what happens after the IPO? Would this company be able or willing to switch Exchanges? Most likely, not. Why would they do this. Switching Exchanges it expensive, time consuming and distracts and confuses shareholders and traders alike. This company won’t be perturbed in the least with insider trading issues.

This is horrible, right? Well, not really. As we have shown above, insider trading is just trading; nothing more and nothing less. There is no reason for a free market to punish a trade. So, what will a free market do? Nothing. The free market will simply absorb the risk. Traders would become aware of it, customers will become aware of it and companies will become aware of it. So what? Nothing, really.

The markets will treat insider trading as just another risk and will become part of the landscape, a non-event, which is where it should have been left to begin with.

CONCLUSION

The whole issue of insider trading is just another example of bureaucrats creating issues from thin air to justify their jobs in the same manner they create money out of thin air to pay themselves. Insider trading is as ridiculous as it gets. Yes, your government at work. Yet another piece of information for you to chose. Chose well.

Note: please see the Glossary if you are unfamiliar with certain words.

 

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