The US has been the prominent pursuant of investors who, after having undisclosed information about a corporation try to exploit it by either buying or selling according it. The Wikipedia definition is "any individual who trades shares based on material non-public information in violation of some duty of trust", not limited to people who are part of the specific company but to all others who use such information to their benefit. The rationale for going after people who trade as such is simply that they are taking advantage of people with less information than their own.
The other side of the coin promotes that people with inside information should not be persecuted but instead, in the words of Milton Friedman "You want more insider trading, not less. You want to give the people
most likely to have knowledge about deficiencies of the company an
incentive to make the public aware of that." Others, argument that insider trading is a victimless act, meaning that those who were going to sell were going to sell anyhow, thus the fact that their counterpart has more information does not affect them. Nevertheless, this rather simplistic argument does not take into account that if a person is presented with more information he might change his mind from selling his current position. Thus, the seller is prevented from reaching a decision under full information. Obviously, those who argue that this kind of asymmetric information is legal in other practices such as real estate, are making the argument that if something bad is happening somewhere else then we should let it happen elsewhere even if we can control for it.
Friedman's argument brings to mind the theses of the Efficient Market Hypothesis (EMH) and the Noise Trader approach. The former, as already discussed, suggests that all available information (either past, present or future, public or private) has already been reflected in the stock price, thus making the market efficient and inappropriate for gaining from them. The latter states that in a stock market, there exist two types of agents: noise traders, who trade erratically and irrationally and rational ones. The noise traders, who even under erroneous beliefs can dominate the market and earn significantly higher returns than rational investors, are responsible for the stock market deviating from fundamental values and they are keeping arbitrageurs from correcting those values (the interested reader may have a look here, here and here for more details).
Returning to the argument, Friedman implicitly assumes that the markets are not efficient but if insiders with more information come to dominate the market then noise traders would diminish thus making markets fully efficient. If someone has information which is useful in estimating a company's future prospects (regardless of the way the estimation is done) then his knowledge would alter the company's stock price, even slightly, to his favour. No trader with new information is ever small, no matter how large the market is. The only difference is that if a trader has private information about a company and that information will never become public, then he stands no chance of ever winning in the stock market no matter how important his information is.
Although this is a rather strange thought, it is easy to understand: if I have information that a company faces trouble but no-one else has that information then I would sell the stock short in order to make a profit from its fall. However, this fall will not occur until the rest of the crowd finds out about it as well. The crowd has no incentive to sell the company if they do not have that information: for them, the company is doing as great as always and no news to the opposite have come to shutter that belief. In addition, the ends do not justify the means either: the public would be aware of that but the only way that insiders would ever disclose such information would be if they stand a chance of winning from it. Thus, they would not be doing it for the public's benefit and neither would the public be benefited from this new information. In fact, new information would increase the duration of the effect as it would start with the insiders' trading and finish when the stock market had assimilated the effect (to be fair it might decrease volatility in the market since prices would not have to adjust so rapidly; still that would depend on the state of the economy, the current trend in the market and so on).
Thus, any inside information trading is bound to disrupt the current market state; although readers may assume that this happens every time new information presents itself, I would like to remind you that this is not a collective action: the market shifts because of the action of some individuals who are in fact determining the price of a stock based on their beliefs and information. This is essentially the same as stock manipulation: the motive to earn a greater return than others, exploiting information others do not have (in the original case the public had no idea that someone was manipulating the stock while in this case they have no idea that new information exists).
The above, make the simple case that if private information was obtained by a person and used in such a manner as to secure a profit, it would only be illegal if that information was to reach the public at a point in the future; if the information was to remain private then no such case would hold. In fact, this also brings forth an issue of importance: it is not the information per se that matters but the timing of that information. As a recent experiment (whose link I was unfortunately unable to find) has shown, those investors who (on purpose) received information on the CPI publication minutes before the actual were published gained on average more than those who received it later. The information on the CPI would have been practically useless if they had received it 3 months prior to the actual publication as the stock market would have demolished their potential profits. In common parlance the investor would have been "too smart for his own good". (The same holds in experimental game theory as participants who understood the game before everyone else faced the problem of being right too soon, thus losing their bets.)
The main idea of all the above arguments can be put simply in just a sentence: insider trading is knowing information sooner than the public does but not too soon as volatility would destroy any potential for gain. In addition, you have to be certain that the public will find out that information and that it will subsequently act on it. Thus, instead on focusing on information which could potentially be used by insiders we should focus on the people who can get that information just minutes before everyone else does and act on it. Inside information is nothing more than timing and not new information.
Friedman's argument brings to mind the theses of the Efficient Market Hypothesis (EMH) and the Noise Trader approach. The former, as already discussed, suggests that all available information (either past, present or future, public or private) has already been reflected in the stock price, thus making the market efficient and inappropriate for gaining from them. The latter states that in a stock market, there exist two types of agents: noise traders, who trade erratically and irrationally and rational ones. The noise traders, who even under erroneous beliefs can dominate the market and earn significantly higher returns than rational investors, are responsible for the stock market deviating from fundamental values and they are keeping arbitrageurs from correcting those values (the interested reader may have a look here, here and here for more details).
Returning to the argument, Friedman implicitly assumes that the markets are not efficient but if insiders with more information come to dominate the market then noise traders would diminish thus making markets fully efficient. If someone has information which is useful in estimating a company's future prospects (regardless of the way the estimation is done) then his knowledge would alter the company's stock price, even slightly, to his favour. No trader with new information is ever small, no matter how large the market is. The only difference is that if a trader has private information about a company and that information will never become public, then he stands no chance of ever winning in the stock market no matter how important his information is.
Although this is a rather strange thought, it is easy to understand: if I have information that a company faces trouble but no-one else has that information then I would sell the stock short in order to make a profit from its fall. However, this fall will not occur until the rest of the crowd finds out about it as well. The crowd has no incentive to sell the company if they do not have that information: for them, the company is doing as great as always and no news to the opposite have come to shutter that belief. In addition, the ends do not justify the means either: the public would be aware of that but the only way that insiders would ever disclose such information would be if they stand a chance of winning from it. Thus, they would not be doing it for the public's benefit and neither would the public be benefited from this new information. In fact, new information would increase the duration of the effect as it would start with the insiders' trading and finish when the stock market had assimilated the effect (to be fair it might decrease volatility in the market since prices would not have to adjust so rapidly; still that would depend on the state of the economy, the current trend in the market and so on).
Thus, any inside information trading is bound to disrupt the current market state; although readers may assume that this happens every time new information presents itself, I would like to remind you that this is not a collective action: the market shifts because of the action of some individuals who are in fact determining the price of a stock based on their beliefs and information. This is essentially the same as stock manipulation: the motive to earn a greater return than others, exploiting information others do not have (in the original case the public had no idea that someone was manipulating the stock while in this case they have no idea that new information exists).
The above, make the simple case that if private information was obtained by a person and used in such a manner as to secure a profit, it would only be illegal if that information was to reach the public at a point in the future; if the information was to remain private then no such case would hold. In fact, this also brings forth an issue of importance: it is not the information per se that matters but the timing of that information. As a recent experiment (whose link I was unfortunately unable to find) has shown, those investors who (on purpose) received information on the CPI publication minutes before the actual were published gained on average more than those who received it later. The information on the CPI would have been practically useless if they had received it 3 months prior to the actual publication as the stock market would have demolished their potential profits. In common parlance the investor would have been "too smart for his own good". (The same holds in experimental game theory as participants who understood the game before everyone else faced the problem of being right too soon, thus losing their bets.)
The main idea of all the above arguments can be put simply in just a sentence: insider trading is knowing information sooner than the public does but not too soon as volatility would destroy any potential for gain. In addition, you have to be certain that the public will find out that information and that it will subsequently act on it. Thus, instead on focusing on information which could potentially be used by insiders we should focus on the people who can get that information just minutes before everyone else does and act on it. Inside information is nothing more than timing and not new information.
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