[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.

[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.

[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.

[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?

[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.

[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.