Saturday, October 24, 2009

Should We Legalize Insider Trading?

The recent tumult with the Galleon Group has gotten
everyone's attention on "insider trading". That's trading in
the markets on "material, non-public, inside information"
(information not available to the ordinary investor) to
obtain excess profits.

However, not everyone agrees that "insider trading" is
necessarily a bad thing. In an article in the Wall Street Journal,
Donald J. Boudreaux, an economics professor at
George Mason University, makes a compelling case that
prohibitions on insider trading actually prevent the timely
flow of information to markets.

How? Let's use a couple of examples. Let's say I am the CEO
and principal of Fans Of The Vampire Squid LLC, a hedge fund.
In the course of working my connections on the Street, I hear
from someone "in the know" that ABC Corporation is about to
post substantially greater earnings for the third quarter than
expected. According to my research, ABC has become a dog
and I'm not only thinking about selling my small position
but shorting the stock as well. But because of the inside tip,
I hold my position but don't add to it lest I be accused of
trading on "material, non-public inside information".
And, I avoid the sure loss that would have occurred had I
shorted the stock.

In other words, thanks to inside information, I make a
small profit and avoid a big loss by doing nothing.
And can I be prosecuted for this? Absolutely Not.

But, there's been a cost. For fear of prosecution,I've
been denied the opportunity to get in at the beginning
on a quick kill - which is what my clients pay me to do.
And by my making my "quick kill", relevant information
actually gets to the market sooner than it otherwise
would - which, in a perfect world, should be the object
of reasonable securities regulation.

But we don't live in a perfect world. And in the markets
players that are large, well capitalized, and able to
procure private information and act on it more quickly than
others have an advantage . And big players - Goldman Sachs
for example - have spent millions of dollars to both facilitate
the discovery of "material non-public inside information"
and act on it more quickly than anyone else.

Maybe this is how "The Squid" can make fully 80%
of its third quarter revenue on proprietary trading
and have over 90% of its trades be profitable (GS actual
3Q numbers - hat tip to Zero Hedge).

But does all this mean that the average trader or investor
shouldn't participate? Not necessarily. The Squid (and
all the other big boys) can make millions from tiny moves
in stocks, options, or fixed-income instruments or
their derivatives. They receive "material non-public
information" about thousands of different issues
every day. That's what a Research Department is for.
And in many cases, the "inside information" only moves
a particular issue a few pennies. Doesn't matter - when
you are trading tens of millions of shares at at time,
that's still millions of dollars in profit at the end of the

Just understand that if you're the average trader
or investor,you can't duplicate this even if you have
the same information - on your micro scale of operation,
your transaction costs are likely greater than your profit.

But the biggest issue I have with "illegal trading on
insider information"? It's that for some reason, the
SEC and the Justice Department never go after
the Big Boys - it's always some small-time accountant,
broker, or small-time operator like Galleon who gets
pinched. That's not right. The rules should be the same
for the big guy as well as the small. And when the
regulators start using enforcement "discretion"
to ignore "insider trading" when it facilitates
"market making" or "providing liquidity to the
market", then the whole premise of regulation is
lost, along with the legitimacy of the regulators.

But are we likely to "de-regulate" the market
for corporate information? In today's political
climate, not likely. And will the "regulated"
still be able to control the market for "material,
non-public, inside information" for their own
advantage? Absolutely.

Even if we were to snap our fingers and declare
"insider trading" legal, nothing would change.

Remember, Wall Street is a Casino. And Goldman
Sachs, JP Morgan, Morgan Stanley and the others
are to The Street what MGM Grand, Harrah's ,
and Wynn's are to Las Vegas - they are THE HOUSE.

And the House always wins. So gamble -
I mean trade or invest - accordingly.

1 comment:

  1. Well put. I am for legalizing insider trading, the biggest reason being inside knowledge becomes public knowledge the faster it spreads. "small" investors simply need to stop being small by gaining leverage thru any means. Borrow from the Mob if you have to. How do you think Donald Trump gets out of bankruptcy every time? By borrowing by the billions to make many more billions.

    Wall Street and big corporations own everything- they own the Fed too. End the Fed. Alan Grayson AND Ron Paul and many others in Congress want to end the Fed. That says something. Only if the SEC were packed with dyed in the wool socialists would they have the correct ideological bent to go after every single entity on Wall Street- lets be honest EVERYONE DOES INSIDER TRADING! and it is unfair to only go after the smaller fish.

    However, due to the big banks and corporations' control of the economy, any action against them would cause an economic meltdown. Now I say so be it. We can't remake the economy that respects Main Street and that has 100% American values of honesty, hard work, and fair play if the same douchebags still hold all the money. Simply put we have to burn the economy down to have it grow back on a more secure and fair footing. We have to burn down the forest to save it otherwise we will be in for a long and arduous dark age of Republican-style voodoo economics that favors the 1% and condemns the rest of us to serfdom.

    Obama isn't hope and change he is Republican-lite. On the biggest issues, he is a speech-making yet do-nothing poll-loving focus-grouped coward. That is the Bad Obama nobody voted for. Everyone voted for the Good Obama the one that waxed poetic about Hope and Change and promised immediate and big actions. Meanwhile the GOP dragged their feet, yelled, teabagged, and bellowed from their dungeons of ignorance on domestic issues and Obama has done virtually nothing about it. De Facto Obama has been ineffective so far on just about everything. Something needs to change. We need More Change and More Hope since not enough is happening on the economy, health care, and other issues.