We’ve long been on the record as sceptics of insider trading enforcement. The case against Raj Rajaratnam has revived all our doubts.
Some of the charges seem like criminalizing the game of telephone that makes up a lot of the information gathering by traders. The charges depend on extensions of legal doctrines that were already far adrift from the actual statutory and regulatory basis on which they were built.
Just look at the charges about Google: the Accused Trader heard from Person A who heard from Investor Relations Tipper who heard from Google Insider that earnings would be poor. At some stage, you have to wonder when in a long train of information that taint of illicit breach of confidentiality just washes off. What’s more, when someone in that chain–we forget who because there are just too many links–demanded money, they were turned down. This wasn’t some nefarious plot using cut-outs and black bags full of cash.
The federal government appears to be in some sort of financial panic. It is using the kind of tactics developed to fight mobsters and terrorists to detect violations of something called Rule 10b-5. But mobsters and terrorists have genuine victims, often easily detectable by their corpses. Who is the victim of insider trading? It is some theoretical person who may not have traded if he had the same information as the alleged insider trader. But markets are dominated by asymmetric information, so this is pure nonsense.
Fortunately, some are offering a more sober view of insider trading. In the weekend edition of the Wall Street Journal, Donald J. Boudreaux argues that “Federal agents are wasting their time slapping handcuffs on hedge fund traders like Raj Rajaratnam.”
“Insider trading is impossible to police and helpful to markets and investors,” Boudreaux argues.
Here’s a summary of his major arguments against criminalizing insider trading.
- Outsiders benefit from insider trading. When insiders sell stocks because they know bad news is coming, the price of the stock reflects that selling. This helps prevent outsiders from buying stocks at prices inflated because of corporate secrecy.
- Avoiding insider trading in inefficient. When a trader gets hold of insider information from a tainted source, the law says he should avoid trading. In other words, Rajaratnam should have told his traders he wasn’t allowed to influence their trades because he knew too much. This means prices will adjust more slowly to the information in the market.
- Malinvestment hurts the entire economy. During the time while prices are lying about the health of a company, the market will divert lots of resources in its direction. Investors will provide capital and creditors will lend money. Healthier companies will find it more difficult to raise capital or borrow. Money that could be better spent, will be wasted. In short, the ban on insider trading damages the entire economy.
- Investors worried about insider trading will diversify. Perhaps the costliest mistake an investor can make is to believe that he or she can time the market and pick stocks. This problem is made worse when investors have a false confidence that the market is a level playing field. Investors fearful of insider trading in individual stocks will be more likely to diversify their investments so that they can benefit from the insider trading instead of losing out to it.
- There’s no way to police insider non-trading. Inside information doesn’t always lead to buying stocks. Sometimes inside information on stocks leads to the conclusion that a stock should not be bought. If Rajaratnam had used the tip from Roomy Khan to avoid buying Google, rather than actually shorting it or selling options, he would have committed no crimes. But this kind of insider non-trading is undetectable and no one argues that they “harm the markets.”
Rather than a single national policy on insider trading, these matters are best left to individual companies and private litigation. Each public company should be free to set the level and type of insider trading it will allow, and pursue employees who violate those policies through private, civil litigation. Since there is no genuine public harm involved, there should be no governmental enforcement.