If you’ve been following the financial and business press, you’ve read about the new, very high-profile insider trading scandal at SAC Capital. Basically, before he fired him, Steven A. Cohen used to employ an analyst named Mathew Martoma. Martoma was analyzing stock in Elan, a pharmaceutical company in which SAC held a very large stake. Martoma had been ‘consulting’ with a doctor whom he found via the Gerson Lehrman “expert network.” This doctor was involved with clinical trials of a potentially lucrative Alzheimer’s drug that Elan was developing. At a certain point, the ongoing clinical trials went sour, as the researchers discovered bad potential side effects. The doctor has told prosecutors that he informed Martoma of this, before this information had been publicized. Martoma, soon after this conversation with the doctor, contacted Steven A. Cohen. Soon after, SAC Capital sold its stake in Elan, then shorted the stock, and made billions.
The case is attracting a lot of attention, because of all the ethical questions involved–do doctors’ consulting fees corrupt? do ‘expert networks’ necessarily facilitate corrupt insider trading?– and because Steven Cohen has been such a successful investor for so long. But it raises the broader, more interesting question: what’s so bad about insider trading in the first place? I think a lot of people haven’t seriously questioned that insider trading is a bad thing. I think it may be, but the reasons for why insider trading might be bad are very much non-obvious.
Let’s go back to the basics. Every single trade in a stock market is both (1) consensual and (2) in a certain sense adversarial. That is, (1) both parties to any given trade are willingly trading, each thinking it in their best interest, and (2) they have contradictory predictions for the asset — the seller thinks the asset will, at the price they are trading it at, return less than the market rate, while the buyer thinks it will return more than the market rate–so one party’s loss will be the other’s gain. (1) means that it’s hard to see how any trade in a financial market is intrinsically immoral–they’re both economic acts between consenting adults–and (2) means that it’s hard to see why any trade could be considered especially exploitative–after all, in every trade, each party is trying to profit from the other’s error, and only one succeeds.
How does insider trading differ from normal trading in financial markets? Well, insider trading is just when one party is placing a trade based on information that is not yet formally ‘public.’ What makes this kind of trading wrong? Does it do anyone any harm? Not directly, but perhaps very indirectly. Look at it this way: When you make a trade based on public information, you’re usually entering into a very liquid, very deep market for that asset, which means you are simply ‘taking’ the price in that market. So your counterparty–the person on the other end of the trade–is making the exact trade (s)he would have made in an alternative universe in which you did not have that insider information. So you’re not directly doing your counterparty any harm by using insider information. Now, theoretically, if you’re making a very large volume of insider trades, you could change the price of the asset (driving it up if you are a buyer, or driving it down if you are a short seller), which would, e.g., make the asset more expensive for other buyers, who would consequently not make as much of a profit once the inside information is made public. But these harms are very indirect. More, they’re balanced out: if your trades, based on your insider information, raise the price of an asset, you’re hurting buyers, but you’re helping sellers.
But this isn’t a complete defense. There is, of course, another standard of ethical behavior, beyond ‘do no harm,’ and it is fairness. Doesn’t the insider trader gain an unfair advantage over others? Perhaps. But it’s not immediately clear what, philosophically, distinguishes trading on insider information from trading on superior analysis. If you have access to a financial model and financial software that your counterparties do not, and these models and software allow you to make better predictions about the future, you’re also ‘taking advantage’ of counterparties who have inferior models, and changing the price of the asset in a way that makes some other buyers/sellers capture less of the benefits of future price movements. What fundamentally distinguishes the two?
So, as I said, the reasons why insider trading is immoral, and the mechanisms through which it causes material harm to people, are very much non-obvious.
Indeed, while there are highly distributed ‘harms’ to insider trading, an argument can be made that there are even greater distributed benefits. After all, what is the most fundamental purpose of capital markets? Intro economics tells us it is to allocate capital efficiently. That is, financial markets exist to get equity and loans to those enterprises that will make the very best use of them. Suppose that a private company is about to go public. Suppose you have insider information that suggests that the growth prospects of this company are much better than is generally supposed. The best thing you can do, for yourself and for society in this situation, would be to make known your commitment to buy as many shares as possible, which would drive up the IPO price of the company, which would bring more capital to this company. To generalize this thought experiment: If you want markets to efficiently allocate capital, you should want them to incorporate all relevant information as quickly as possible, without regard to whether that information is legally, formally considered public or private. By bringing more information into the market, insider trading, this argument goes, benefits us all. Indeed, an investor who short-sells a stock on insider information and thus drives its price down is actually benefiting future investors by bringing the assets price closer to the ‘true’ value, which the market will reach once the insider information is made public.
So you can tell a story in which Mr. Martoma’s insider trading actually did good for the world. He got his firm to take some capital out of Elan, freeing that capital up to go elsewhere, to some firm that had better future prospects. And his insider trading helped drive the price of the stock down to its “true” value, so that future investors actually lost less money when the clinical trials were made public.
So, then, why do developed nations ban insider trading? There are a couple traditional arguments, a couple more sophisticated ones, and a few more I’ve just thought up.
The most traditional argument is that if insider trading is widespread, ‘retail’ investors (individual people–you and me) will be less likely to participate in stock markets, because they’ll know full-time financiers have a huge, special informational advantage over them. People might feel that way. But should they? After all, if insider trading is rampant, that means more not-yet-public knowledge is incorporated into stock prices, which will mean that our bets will be less likely to go really sour (i.e., the stock price of Elan would already reflect the bad clinical trials–so we wouldn’t lose a lot of money when it got announced, if we had bought the stock).
A more sophisticated version of the argument, highlighted by Professor Stephen Bainbridge, argues that insider trading causes harm by inducing investors to make bad purchases. For example, if your analysis of publicly available information suggests that the value of a stock should be $20, but the stock is trading at $16, you’ll naturally want to buy. But if the reason the stock is trading at $16 is that its price has been driven down by people who secretly have access to insider information that suggests it will tank in a few months, then you’ll have gotten screwed; you would not have, in this case, gotten screwed if the insider traders had never gotten involved, and the stock had been trading for $20, where you wouldn’t have bought it, because you wouldn’t have gauged it to be under-priced. A market effected by insider trading has, consequently, ‘induced’ you to make a bad purchase that you otherwise would not have made.
I think this is the best argument that insider trading does harm to individual people, but I’m not sure it’s a super-compelling argument that it should be banned. After all, there’s a buyer for every seller in every trade, so as many people benefit from insider trading’s ‘mispricings’ as are hurt by it — society as a whole does just as well. More, if insider trading were legal and common, you would take that into account in valuing an asset, and wonder, upon seeing a really good deal, if somebody knew something you didn’t. More, if, in our highly-financialized economy, the two parties to any trade are usually enormous financial institutions, it’s not clear how much we should really pity the one which got unfairly screwed.
So I am, at this point, unpersuaded by the traditional arguments for forbidding insider trading. But I think there are other, more convincing arguments. I want to highlight two arguments, one of I found in a paper, and one of my own.
As I suggested above, overall, an individual investor isn’t necessarily more likely to get screwed when trading in a market with insider trading. But the investor might feel that way, and he might be particularly outraged when, if one of his bets goes bad, it can be attributed to insider trading. Even though you can theoretically expect the same return in a market with insider trading, your feelings of outrage, abuse, and having been taken advantage of, will make you less likely to invest in that market. That seems to be why, as this study found, enforcing laws against insider trading helps to lower the overall cost of capital, because those laws make people more willing to invest, all else equal. In transparent markets that appeal to people’s feelings about fairness, people feel more comfortable, more in control, and therefore more eager to get involved. Lower costs of capital mean that more firms can profitably make more investments, which makes us all more prosperous over time. (In this vein, though, laws against insider trading are helpful only as a concession to emotional human feelings of outrage, etc., rather than as things that are objectively needed to make markets work.) [[EDIT: My friend on Twitter argues, “Liquidity depends on people being willing to trade with you. Insiders in market make people suspicious, reduce liquidity.” I think this seems a better way of putting this basic thought. Without insider trading, if you have faith in your own stock analysis, you just assume your counterparty isn’t doing his analysis of the stock correctly. But if your counterparty might be an insider trader, you worry that she knows something you don’t, get suspicious, and maybe refuse to trade at all. That causes a lot of broader harms to capital markets.]]
I would like to proffer another argument, which I haven’t yet seen elsewhere, but I imagine someone else has likely thought of. Insider trading gives investors incentives to spend more time doing research and analysis that is not socially useful. By which I mean this: What social purpose is served by investors spending lots and lots of time trying to get ahead of each other in trying to figure out how the clinical trials at Elan are going? The information is going to be revealed and taken account of eventually, anyways. So firms that invest a lot of resources in trying to get that information are just playing a zero-sum game with no positive externalities (‘externalities’ are things that benefit others as well). But when firms compete to better understand, analyze, and make predictions off of publicly-available information, they’re producing knowledge that is socially useful. If you’re analyzing the stock of a company that is making a big push in China, you’ll make an effort to compete to produce better and better models of, say, what China’s future economic trajectory will be like–you’ll learn how development happens, how companies can best navigate emerging markets. etc. Or if you’re investing in tech, you’ll have to spend a lot of time trying to understand what the world’s technological future will be like–is it a bubble? or are we nearing the technological singularity? The knowledge and understandings that are produced by that research will help us all understand the world better, and therefore help us all allocate capital to the industries, geographies, and technologies where it is most needed. Getting a tip from a doctor involved with Elan doesn’t advance that kind of broader, universally useful understanding. So my thinking is that allowing people to trade on insider information just gives investors too much incentive to dig for particular secrets in a zero-sum game, instead of advancing our understanding of the world more broadly. And that, as we say in economics, is a socially inefficient allocation of resources.