Michael Douglas received an Oscar for his role as Gordon
Gekko in the 1987 film Wall Street. He
remains famous for his line “greed is good”. Aficionados should rejoice: Gekko is
back but in a new role as spokesman of the Federal Bureau of Investigation in
its war against insider trading. His new line: “If a deal look too good to be true, it probably
is”.
Insider trading refers to trades of securities by
individuals based on non-public information. Such transactions are considered
as unfair since one side of the trade has private information that has not yet
affected the price of the security. Therefore, lawmakers consider that insider
trading is bad for financial markets. Regulations to ban trading on inside
information have been introduced in the US as early as 1934. Other countries
implemented similar rules, although more recently (see Bhattacharya and Daouk
1992). This theme keeps lawmakers busy on both side of the Atlantic. In Europe,
for instance, the European Commission is currently working on MAD II, the
second incarnation of its Market Abuse Directive.
Academics are not sure that insider trading is all bad. Leland
(2002) summarized the arguments as follow:
“Pro.-(a) Insider trading
will bring new and useful information into asset prices. Decision makers-both
portfolio managers and firms making real investment decisions-can reduce risk
and improve performance when prices reflect better information. (b) Because of reduced risk, asset prices
will be higher and more real investment will occur.
Con.-(a) Outside investor
will invest less because the market is “unfair”. Asset prices will be lower and
less real investment will occur. (b)
Market liquidity will be reduced, thereby disadvantaging traders who must trade
for life cycle or other reasons not related to information. (c)
Insiders trading will make current stock prices more volatiles, further
hurting traders with liquidity needs.”
Sorting through these arguments will take time and the
outcome is uncertain. It should be based on empirical evidence. Measuring the
benefits of insider trading requires calculating the difference between the
“wrong price” and the “right price”. In a beautiful paper, Liza Meulbroeck (1992)
analyses stock price effect of insider trading in the US. She finds that “the
stock market detects the possibility of informed trading and impounds this
information into the stock price.” Markets might be better than regulators to detect
insider trading. More recent evidence is badly needed. Stephen
Bainbridge, a law professor at UCLA, provides a legal viewpoint on his website
ProfessorBainbridge.com.
Gordon Gekko might have been right in the first place.
References
Scannell, K. (2012),
FBI casts Wall Street’s Gekko to remind traders greed is no good, Financial Times, February 28 2012
Bhattacharya, U. and H. Daouk (2002), The World Price of
Insider Trading, Journal of Finance
62, 1 (February) 75-108
Leland, H. (2002) Insider Trading: Should It be Prohibited?,
Journal of Political Economy 100, 4,
859-887
Meulbroek, L. (1992) An Empirical Analysis of Illegal
Insider Trading, Journal of Finance
47, 7 (December) 1661-1699
