[lambdapie]

Insider trading does harm people, and does reduce liquidity. Many people who understand classical economics get this wrong [0], because financial markets are a very degenerate kind of market from the point of view of classical economics.

The fundamental error in all cases is to conceptualize insider trading as buying from someone who would have bought/sold anyway. This is precisely failing to think at the margin. It is as erroneous as saying "eating meat is ok because those cows would have been killed anyway". Put more technically, when you buy a share, you do so by shifting up the demand curve a tiny bit, with your demand, which in turn shifts the price slightly up and causes a seller to sell, who would not otherwise have. Market microstructure, together with the fact that supply/demand curves really form a single curve, can obscure this fundamental economic fact.

Given this, insider trading does cause harm to some people. And how could it not? If a person can make money from insider trading, then, to first order, someone else must lose money. There are some externalities from information revelation, but only a tiny fraction of these benefits go to the marginal buyer/seller who lost out because of insider trading.

How does this compare to public releases of information? Well unlike insider trading, public information can shift prices without any transactions occurring (or in practice, very few). This is because while insider trading only moves the price by the mechanism of moving the supply/demand curve, while public information is revealed to all traders at once.

So while insider trading does reveal information (which is a good thing) it does so in a way that reduces liquidity, because people don't want to be on the wrong side of insider trading.

I'll admit that the above narrative isn't watertight. I think it's the best analysis that can be done verbally. The only models that allow a meaningful discussion of welfare in the context of financial markets are so called noise-trader models, which explicitly model the (irrational) reasons why most people trade. The whole field is vastly complicated by the fact that theory predicts almost no trade in stocks if people were completely rational.

[0] http://www.marketwatch.com/story/why-insider-trading-should-...

[bobcostas55]

You completely ignore the benefit of the more accurate price.

Let's say the price of a share with the inside info is 110. It is now 100. The inside trader does cause some volume that wouldn't have happened otherwise, and moves the price to 105 -- to the detriment of someone who would not have traded otherwise. But then every subsequent trade is at a price closer to the true one, a clear benefit.

It is true that greater information asymmetries will decrease liquidity/widen spreads, but is this a sufficient justification for banning inside trading? Also, information asymmetry is a matter of degree, not a binary thing. A skilled fund manager may have assembled public information (the "mosaic" view) that when put together is tantamount to insider info. You could use the exact same argument to ban him from trading.

[lambdapie]

I wouldn't say that I ignored the benefit or a more accurate price, since I explicitly mentioned this benefit twice. But I wasn't clear enough of the implications. To clarify: insider trading has both benefits and costs, and there is no simple argument that shows which is greater. I was primarily addressing people (like in the article I referenced) who say that insider trading is clearly and unambiguously good.

[joe_the_user]

Theft benefits the thief while costing the person stolen from.

If one can backup and use a fuzzy enough lens, one can just ask "how should society calculate the total benefits here" but the problem is this begs the question of whether it's proper for the state to just ask these questions.

My impression is that none of the insider trading proponents are also proponents of the view that it's not theft to take money that falls off the back of an armored car because "it's hard to who it belongs to" and "we might well benefit from this money more than whoever it really belongs to" but their arguments seem the same. Further, the average people finding money on the street probably really do need it more than your average insider trader.

[thaumasiotes]

> Theft benefits the thief while costing the person stolen from.

> If one can backup and use a fuzzy enough lens, one can just ask "how should society calculate the total benefits here" but the problem is this begs the question of whether it's proper for the state to just ask these questions.

But in the case of insider trading, there is no such person. Lambdapie identifies that there is a cost (yes!), but that cost only exists at a fuzzier level than "the person stolen from". Trying to examine at a finer level doesn't make sense.

[wavefunction]

What if you considered the lost "profit" the non-insiders would have made from buying at 100 rather than 105, or 103, or whatever price results from normal speculative activity?

[thaumasiotes]

Can you sketch a more concrete example of what you're talking about?

[Natanael_L]

But there's also bad incentives tied to it - with inside information, you're incentivized to keep others in the dark so that you can maximize the impact of your trades. Things like borrowing money to short stocks in a company likely to go bankrupt, while telling people to buy.

[evanpw]

> with inside information, you're incentivized to keep others in the dark so that you can maximize the impact of your trades

This is true of all professional trading.

> borrowing money to short stocks in a company likely to go bankrupt, while telling people to buy

This would be fraud, which is illegal independently of any insider trading rules

[baddox]

Why does borrowing money in any way diminish the positive effect of making the stock price more reliable?

And how does the incentive to lie to other traders apply only to insider trading? It seems like that would always apply to all trading.

[Natanael_L]

Like I replied to another comment, should judges be allowed to trade on information about judgements he has yet to deliver?

[baddox]

I don't think so, but I think that could be handled on the side of the court, not the side of the exchange. It could certainly be illegal, or at least a disbarrable offense, for a judge to use his or her knowledge for personal gain. Likewise, many of the most flagrant examples of insider trading could be covered under trade secret or contract law, like a CEO shorting his or her company then purposefully sabotaging it.

[giaour]

That sounds like a question for a professional ethics board. I would assume a judge caught doing that would be sacked, disbarred, and publicly shamed, even if everything he did was strictly legal.

"Wrong" doesn't automatically mean "criminal."

[JacobH]

Telling people to buy stock you shorted is a bad idea. You're goal is for the stock to go lower.

[lmm]

Yeah but conversely you want to talk the price up before you lock in your short so that you get in at a better price.

[Natanael_L]

> bankrupt

Should deal with that

[eru]

> Things like borrowing money to short stocks in a company likely to go bankrupt, while telling people to buy.

It's a dick move, but seems perfectly legal.

[joe_the_user]

You completely ignore the benefit of the more accurate price

The gp does a good job of describing how insider trading actually takes money from particular people. Are you saying that a certain number of people should have their money taken in order that prices are closer to predicting otherwise unknown results? Something like "by eminent domain, we are taking your investment profits for the great good of accuracy in stock prices".

Moreover, the other people who benefit from price jumps from invisible sources are those who don't know anything but who are willing to gamble that these price jumps represent a real increase in value. The existence of such gambling would seem like it increases the overall volatility of the market and given that such gamblers would tend to magnify random jumps in the market as well, it seems like society broadly would not experience any benefit.

[beagle3]

The problem is that insiders can actually (and easily, and even subconciously) change that price.

Let's say I believe that the company I work with is horribly mismanaged. I short it. Then, all of a sudden, an announcement comes ("corp X is going to buy our company") that raises the price and makes me lose my pants. I have two choices now:

a) lose my pants, or

b) use the due-diligence period to try to kill the deal from the inside.

Are you willing to hold stock of a company in which (b) is likely to happen? I don't.

Furthermore, even though a 5% discrepancy is already huge, in many cases it is much larger than that: valeant recently dropped 70% in a few weeks, and insiders knew all about the irregularities1; If allowed to short, a new employee, upon discovering those irregularities, has a great incentives to quit, short, and go to the newspaper. While this would deliver justice much more swiftly to the company, it would do so to the benefit of that individual at the expense of everyone else. We disallow vigilante justice in general for good reasons and this is no different.

[JacobH]

Bad argument because you stated the problem. Insider trading is bad because of what you pretty much said. Liquidity is only important when considering how fast you want to buy or sell your stakes in a company.

If an insider knows a stock will yield him 10% profit and has a month of time to buy stocks, even if the daily volume is 500k shares. They can gradually buy shares at 20k/day, and once that news becomes public and the liquidy goes up they can sell off all of their shares in one shot pretty much. And people just just got news of the information would think that their stock has a 10% upside, but since someone already beat them to the 10%, they aren't going to get anything.

[evanpw]

I basically agree with this, but I don't think it helps that much to answer the question of which trading activities should be allowed, and which should send you to prison. Almost all of what you've said applies equally well if you replace "insider trading" with "professional trading".

If you send a 1000 share buy order to the market, knowing that you're going to send 99 more of them throughout the day, you're making money (or at least losing less money) because of information that you have and your counterparties don't. And that kind of trading definitely has a negative effect on liquidity (almost the whole difficulty in market making is preferentially trading against people who aren't doing this). But this splitting of orders is universally viewed as "ok", and is how most large-volume trading is done these days.

The difference between this and insider trading is in who owns the information. Most people view the large-volume trader as doing something okay, because they own the information about their own future trading behavior. Insider trading is illegal not because it's unfair to trade on asymmetric information, but because you're trading on information that was stolen from the company. (This is why Mark Cuban didn't go to prison: a company gave him some insider information, but forgot to ask him not to trade on it; no stealing involved).

From this perspective, it makes sense to prosecute the original tipper, and anyone in the chain who knew (or should have known) that the information was stolen (by analogy to the crime of passing stolen goods), but not the guys at the end who were clueless about the scheme. (Although it might make sense to make them disgorge their trading profits.)

[mrchicity]

The other difference is that inside information isn't available on a reasonable and non-discriminatory basis. Traders pay for advantages all the time: Bloomberg terminals, news services, hire better analysts, pay someone to count cars in store parking lots, purchase faster computers or data feeds, but anyone else can do the same. Some players have an advantage, but the playing field itself is relatively level.

With inside information, it's not available to people outside the tipping network at any price. This, more than the mere chance of getting "picked off" by asymmetric information, drives traders out of the market, making it less liquid. If they were just losing because they didn't have good enough analysts, they could always compete and hire more. For the same reason, regulators and exchanges try to keep manipulators out of the market even if they bring a lot of volume. Eventually people will lose confidence in the market itself and leave.

[losvedir]

> With inside information, it's not available to people outside the tipping network at any price.

But surely this is begging the question? If there were no laws restricting trading wouldn't information that we currently call "inside information" become available at some price? I could easily see some exclusive, high priced news service selling these leaked facts. It would then cause the "true price" of the stock to be found much, much quicker.

[mrchicity]

I don't think exclusive access would be legal, and if access isn't exclusive, the value of the information would drop, as it's only valuable to the extent that it's not known by others.

Also, simply being aware that such a service exists and can release information at certain times would let uninformed traders exit the market during releases. Right now insider traders can arrive randomly at any time.

[thaumasiotes]

> With inside information, it's not available to people outside the tipping network at any price.

Let's take a stylized version of a recent insider-trading case:

- A company ("Conglomacorp") employs someone ("Big Mouth") to dispense inside information to investors. Usually he does this by sitting in his office and answering phone calls. (This is common, and definitely legal.)

- A particular investor ("Shylock") develops a friendship with Big Mouth, and regularly goes to dinner with him. At dinner, Big Mouth tells this investor company information.

- Shylock trades in Conglomacorp stock.

- It's stipulated that if the information that Shylock received had been dispensed during work hours, there wouldn't have been any legal problems. But he is prosecuted on the theory that, since it was dispensed at dinner, outside of work hours, he should have been aware that trading on it was illegitimate.

How does this case fit in with your ideas of insider trading? It's certainly not the case that "[the inside information is] not available to people outside the tipping network at any price". You have to be a big enough investor that the investor relations desk has time for you, but that's open to anyone.

[mrchicity]

Answering calls with individual investors and giving out material information is illegal under Reg FD. Not sure about this particular fact pattern, but being told something officially vs. over dinner/drinks can have a different expectation as far as confidentiality goes. That seems sensible.

Also, FWIW, and I'm sure this wasn't your intent, but "Shylock" is considered an Anti-Semitic slur by many people.

[eru]

Compare http://time.com/3394403/shylock-biden/

[lmm]

"Reasonable and non-discriminatory" is a technical term, and I think it covers this case. If the company accepts everyone's calls, or everyone who owns more than x% of their stock, or charges you $y/minute, it's fine for them to reveal information that way. Revealing information to individuals that Big Mouth personally decides to go to dinner with is not ok.

[thaumasiotes]

Despite the fact that it's the same information? There's no distinction, in the example, between information that it's OK for Big Mouth to disclose and information that he can't disclose. Such forbidden information might exist and be known to Big Mouth, but Shylock didn't receive it. How can the only problem be that it was disclosed outside business hours?

[lmm]

If it happens in business hours then it's Conglomacorp's job to supervise Big Mouth properly and make sure he's not playing favourites (which as your sibling points out would be a Reg FD violation). If Shylock wants to trade on information then he needs to get it through the official channel where it's subject to compliance monitoring and all the rest of it. I'm fine with it being a crime for him to get information from Big Mouth in a way that bypasses those processes even if it turns out those processes wouldn't actually have blocked the information in this case.

[mrchicity]

https://en.wikipedia.org/wiki/Regulation_Fair_Disclosure

[evanpw]

I agree that there are legitimate reasons to restrict insider trading, but I think that the "fairness" angle distorts more than it illuminates. Warren Buffet's trading plans for next year are not available to me at any price, and he can probably be 95% confident that after announcing he owns a stake in some company the price will jump, but I (and probably you) don't think that means he should go to prison.

[mrchicity]

Anyone buying a lot of shares will move the price up. Buffett makes money because he buys shares under their future value despite moving prices in the short-term, not because of it. Anyone can try to become as smart as Buffett, hire away his analysts, and so on.

[evanpw]

> Anyone can try to become as smart as Buffett, hire away his analysts, and so on.

Anyone can try to schmooze corporate insiders so that they tell you some juicy information. And that seems a lot easier (theoretically and empirically) than becoming Warren Buffett.

[baddox]

I think the main trouble I'm having with your argument is the idea of it "harming" someone. While that seems to perhaps be true in the most technical sense, I'm not sure it's a sufficient argument for banning insider trading. After all, many things which harm people are not generally considered to be bad. For instance, if someone opens a restaurant Ina town, and runs the restaurant very efficient while offering a high quality product, that could absolutely harm other competing restaurant owners. And yet most people do not condemn the practice of opening a restaurant and operating it well.

[lambdapie]

You are right that "harming" someone is not a sufficient reason to ban an action. And as others have pointed out, researching a company carefully causes the same kind of "harm", and certainly shouldn't be banned. My intention was to refute people (like in the article I linked) who argue that all market participants benefit from and insider trader's transaction.

Once we see that this isn't the case, it becomes necessary to do a cost benefit analysis to determine the true effect of allowing insider trading. But as you say, this should be done on a utilitarian basis, not on some imagined "rights" of the counterparty to insider trading. (EDIT: I don't mean to imply that economic analysis from a utilitarian POV can't clarify what we should think of as people's rights, but rather that as you said, causing someone else to have a negative outcome does not prove that someone's rights are being violated)

[Natanael_L]

Should judges be able to trade on the information about companies be is about to deliver judgements for? Should city planners be allowed to trade on the information on approvals / denials before they're announced?

[baddox]

I would hope that both of those examples would be prohibited by the terms of their employment.

[lambdapie]

Some other commenters have correctly pointed out that (1) my comment doesn't address whether the liquidity costs outweigh the benefits of extra information, and (2) why insider is different to outsiders doing research.

I do implicitly address these issues in my comment, when I compare public information with insider information. Noise traders are the goose that lays the golden eggs[0]. They irrationally trade randomly in a stock, masking the trades of informed traders. They make a trading loss on average, and these losses provide the profits of informed traders, which gives those traders the incentive for price discovery.

Although the simplest noise trader models can't capture this (as all information takes the same form) [1], public information is much less costly to the noise traders. So for example, noise traders lose a lot more if a company's earnings are leaked to a few individuals, than if these earnings are made public, because in the latter case the market maker can distinguish information from the the noise trader's trades.

So (and again, a model is really needed to confirm this) public information is cheaper in terms of its impact on liquidity, than insider information. One thing I'm not certain of is whether many insiders competing to trade on the same information would be as good as public information.

[0] See the seminal work of Kyle (1985), http://www.jstor.org/stable/1913210 and also the review article http://scholar.harvard.edu/shleifer/files/noise_trader_appro...

[1] Giving the market maker access to a meaningful information set would resolve this issue.

[ikeboy]

See http://clsbluesky.law.columbia.edu/2015/10/25/whats-the-harm...

[lambdapie]

I didn't understand that article, probably because I'm unfamiliar with the author's other works. Is he proposing that a company be allowed to set rules regarding insider trading during the IPO? If so, I agree that in theory this would be efficient (or in the author's terminology, it would be acceptable from a consequentialist POV). But this is orthogonal to the issue. The people who want to ban insider trading would most argue that insider trading is inefficient, and therefore companies would choose not to issue stocks like this. And if they are right, we would still be in the same situation, it's just that instead of people violating a rule created by the government in order to maximize utility, they would be violating a contract created by the company in order to maximize the company's IPO price (which also happens to maximize utility).

Am I missing anything else? Did the author make a specific argument for why insider trading would prove to be efficient (i.e. why the effect on liquidity outweighed the increased information revelation?) I doubt it since the author's language suggest someone familiar with law and philosophy but not so much finance and econ.

[ikeboy]

The argument is that instead of having the government decide what's best, the company should decide (and it doesn't need to be during the IPO). Then, the so-called "free market" will decide whether it's good or bad. If they decide it's bad for companies, then companies won't allow it, because it will hurt their stock price. If they decide it's good, then companies will allow it.

[lambdapie]

Why is free market in scare quotes? And why "so-called"?

[ikeboy]

Because obviously the market won't be completely free: companies deciding on their policy in the proposed regime would most certainly be influenced by factors beyond the question of whether it's good for their stock price.

[lambdapie]

Ok that's reasonable. I agree that in theory this argument makes sense. In practice I think the arguments that insider trading is inefficient are compelling enough (see https://news.ycombinator.com/item?id=10487779) that it's not worth pursuing this course.

[lumberjack]

It also gives people in the C-suite perverse incentives especially at large publicly traded corporations, as if they do not already push for short term gains as much as possible.