Why forbid insider trading?

The prevention of insider trading is widely treated as an important function of securities regulation. In the United States, which has the most--studied financial markets of the world, regulators appear to devote significant resources to combat insider trading. This has led many observers in India to mechanically accept the notion that the prohibition of insider trading is an important function of SEBI. In most countries other than the US, government actions against insider trading are much more limited. Many countries pay lip service to the idea that insider trading must be prevented, while doing little by way of enforcement.

In order to make sense of insider trading, we must go back to a basic understanding of markets, prices and the role of markets in the economy. The ideal securities market is one which does a good job of allocating capital in the economy. This function is enabled by "market efficiency", the situation where the market price of each security accurately reflects the risk and return in its future. The primary function of regulation and policy is to foster market efficiency, hence we must evaluate the impact of insider trading upon market efficiency.

It is not hard to see that when company insiders trade on the secondary market, they speed up the flow of information and forecasts into prices. Company insiders are in a unique position to make forecasts about the future risk and return of the shares and bonds of their company, hence they might often correctly perceive market prices to be "too low" or "too high". When they trade on the secondary market, they serve to feed their knowledge into prices, thus making markets more efficient.

Insider trading is often equated with market manipulation, yet the two phenomena are completely different. Manipulation is intrinsically about making market prices move away from their fair values; manipulators reduce market efficiency. Insider trading brings prices closer to their fair values; insiders enhance market efficiency.

This is one of the situations where the insights of modern economics contradict common intuition. The fact that securities regulation in the US is primarily the creation of lawyers is not unrelated of the fact that the US is unique in emphasising restrictions on insider trading.

Insider trading appears unfair, especially to speculators outside a company who face difficult competition in the form of inside traders. Individual speculators and fund managers alike face inferior returns when markets are more efficient owing to the actions of inside traders. This does not, in itself, imply that insider trading is harmful. Insider trading clearly hurts individual and institutional speculators, but the interests of the economy and the interests of these professional traders are not congruent. Indeed, inside traders competing with professional traders is not unlike foreign goods competing on the domestic market -- the economy at large benefits even though one class of economic agents suffers.

Let us imagine two island--countries with different policy regimes. On island A, insider trading is swiftly detected and severaly punished, hence it is essentially absent. On island B, insider trading is rampant. If insider trading were an unambiguous evil, then island B should clearly have inferior market efficiency. Is that the likely outcome? How would price formation on the two islands differ?

On island B, insiders would play a major role in price discovery. Individual and institutional speculators would find it very difficult to compete, and they would settle into passive strategies like owning index funds. On island A, in the absence of insider trading, market inefficiencies would flourish, which would attract significant resources into research and speculation by both individuals and institutions. Markets would become quite efficient on island A too, but the price discovery would be dominated by retail and institional speculators who stand outside listed companies and subject them to intense scrutiny.

In this analysis, it is not clear that insider trading is intrinsically bad. What is at stake is the monopoly of outside speculators in exploiting market inefficiencies. It appears that both islands can achieve the desired outcome, i.e. a state of market efficiency. Island B expends greater human resources on research and speculation as compared with island A, where these resources become available for other purposes. Hence the insider trading approach is probably a preferable way for an economy to obtain the allocative function of the efficient market at the minimum cost.

In this perspective, the State could enhance market efficiency by imposing a reporting requirement. Since trades by insiders are unusually informative, it would help market efficiency if these were required to be rapidly disclosed. The price, quantity and identity of the insider should be revealed shortly after a trade is consummated. Such requirements are in place in the US today.

Once again, a mechanical adoption of regulation from the US is inappropriate. Given the higher degree of automation of the Indian markets, it is not difficult to imagine a situation where trades by insiders are disclosed to the market within five minutes of the trade being matched by the computer. Such a reporting requirement would harness the informational potential of insider trading, and enhance market efficiency by speeding up the full impact of the trade upon market prices.

Cost--benefit analysis. Even if restrictions on insider trading were considered desirable, their sound implementation is extremely expensive. A wide variety of individuals can be classed as insiders by virtue of possessing information material to securities prices -- top management, upstream and downstream producers, regulatory and enforcement authorities, professional advisors, etc. Further, the universe of associates through whom insiders could route their trades is very large -- family, friends, business associates who are "paid" in information, etc. Enforcement of restrictions upon insider trading runs the risk of either being ineffective or being a witchhunt. Even if there are pockets of high quality enforcement, they would not appear fair in an environment where insider trading is otherwise rampant. Even in the US, where significant resources have been expended on deterring insider trading, there is anecdotal evidence that a great deal of successful speculation continues based on insider trading.

Hence, if we view securities regulation in terms of maximising the impact upon market efficiency given a scarce supply of regulation and supervision, then insider trading would be a low priority.

This article is not about Hindustan Lever, and the highly relevant question about whether the actions of the top management of HLL violated norms against insider trading. Our prime focus here is the widely--held viewpoint that insider trading is a problem which should be a priority on SEBI's agenda. This viewpoint is not supported by economic reasoning. Insider trading might indeed have negative consequences, but there is no simple argument which links up higher levels of insider trading to reduced levels of market efficiency. There are many alternative ways through which SEBI can improve market efficiency, avenues where the impact of policy interventions is less ambiguous and where the cost of intervention is lower.

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