In the United States, insider trading may be legal when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies (their trades must be reported to the Securities and Exchange Commission). Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.
To understand the social benefits of insider trading, we have to first realize that stock prices mean something. They reflect real facts about the world, such as the assets and liabilities of a particular corporation and how effectively its current management is using resources to satisfy customers.
In general, speculators perform a useful social service when they are profitable. By buying low and selling high (or by short-selling high and covering low), stock speculators actually speed up price adjustments and make stock prices less volatile than they otherwise would be.
Obtaining information in illegal ways obviously has actual victims. But the suggestion behind "insider trading" is that somehow if a person financially profits from special knowledge, that he or she is bilking the general public.
In general, this analysis doesn't hold up, as Murray Rothbard has pointed out. For example, suppose a Wall Street trader is at the bar and overhears an executive on his cell phone discussing some good news for the Acme Corporation. The trader then rushes to buy 1,000 shares of the stock, which is currently selling for $10. When the news becomes public, the stock jumps to $15, and the trader closes out his position for a handsome gain of $5,000. Who is the supposed victim in all of this? From whom was this $5,000 profit taken?
The $5,000 wasn't taken from the people who sold the shares to the trader. They were trying to sell anyway, and would have sold it to somebody else had the trader not entered the market. In fact, by snatching the 1,000 shares at the current price of $10, the trader's demand may have held the price higher than it otherwise would have been. In other words, had the trader not entered the market, the people trying to sell 1,000 shares may have had to settle for, say, $9.75 per share rather than the $10.00 they actually received. The people dumping their stock either were not hurt or actually benefited from the action of the trader.
The people who held the stock beforehand, and retained it throughout the trader's speculative activities, were not directly affected either. Once the news became public, the stock went to its new level. Their wealth wasn't influenced by the inside trader.
In fact, the only people who demonstrably lost out were those who were trying to buy shares of the stock just when the trader did so, before the news became public. By entering the market and acquiring 1,000 shares (temporarily), the trader either reduced the number of Acme shares other potential buyers acquired, or he forced them to pay a higher price than they otherwise would have. When the news then hit and the share prices jumped, this meant that this select group (who also acquired new shares of Acme in the short interval in question) made less total profit than they otherwise would have.
The trader didn't bilk "the public"; he merely used his superior knowledge to wrest some of the potential gains that otherwise would have accrued as dumb luck to a small group of other investors.
Stock-market speculation is not a zero-sum activity. Even though we can look at any particular transaction and tally up the "winners" and "losers," the presence of speculators enhances the overall functioning of the stock market. For example, the market for any particular security is more liquid when there are rich speculators who will quickly pounce on a perceived mistake in pricing. If an institutional investor (such as a firm managing pensions) suddenly has a cash crunch and needs to dump its holdings, speculators will swoop in and put a floor under the fire-sale price. This is good for the beleaguered pension fund, and for the stock market in general.
Crackdowns on insider trading are harmful because they chill the cultivation of superior knowledge and speculative correction of market prices. Beyond this loss of general economic efficiency, insider-trading laws are insidious because of the arbitrary power they give to government officials.
More generally, Murray Rothbard argued that every firm on Wall Street is technically engaging in "insider trading." If they literally relied only on information that was available to the public, how could they make any money? Thus, the government has the statutory authority to harass or even shut down anybody in the financial sector who doesn't play ball.
- Insider trading at Wikipedia
- Insider Trading by Stanislav Dolgopolov at The Concise Encyclopedia of Economics
- "Is Insider Trading Really a Crime?" by Robert P. Murphy, May 2011
- "Insider Trading: A Bum Rap" by Gary North, April 2011
- "'Insider Trading' is Back", April 2007
- "Panic on Wall Street" (from Making Economic Sense)
- Insider Trading, Agency Problems, and the Separation of Property and Control (pdf) by Alexandre Padilla, October 2000
- Can Agency Theory Justify the Regulation of Insider Trading? (pdf) by Alexandre Padilla, 2002
- "Our Fascist State and Martha Stewart" by David J. Heinrich, March 2005
- "Martha’s kangaroo court" by Brian Macker, January 2004
- "The Attack on Martha" by William L. Anderson, June 2002
- "The Next Martha Stewart…Not!!" by Dale Steinreich, September 2005
- "Martha Stewart's Surreal Ordeal" by Christopher Westley, February 2004
- "The Dangerous Business of Arresting Inside Traders" by Douglas French, January 2012
- The Regulation of Insider Trading as an Agency Problem (pdf) by Alexandre Padilla
- Martha is Not Guilty by Alexandre Padilla, June 2003
- Wanted for Outsider Trading by James Ostrowski, August 2002
- Wealthy Beyond a Reasonable Doubt by William L. Anderson, March 2004
- Communism in Capital Markets by Illana Mercer, October 2002
- Martha Stewart: Political Prisoner by William L. Anderson, June 2003
- Convicted for Fearing Conviction by Illana Mercer, March 2004
- Securities Regulation and Virtual Crime in Financial Markets (pdf) by Jeff Scott, July 1999
- Panic on Wall Street by Murray Rothbard (Chapter 50 from Making Economic Sense)
- What is Morally Right With Insider Trading (pdf) by Tibor R. Machan, April 1996
- A case for legalizing insider trading by Martin Sibileau, October 2012