How and whether to fight insider trading

By Felix Salmon
June 3, 2013
Jim Surowiecki has an excellent column on insider trading this week.

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Jim Surowiecki has an excellent column on insider trading this week. He claims — without hyperlinks it’s hard to judge this, but I do trust him — that the increase in insider-trading prosecutions isn’t just a reflection of increased prosecutorial zeal, but actually reflects a real uptick in insider trading itself.

Surowiecki sees three main reasons why this might be happening. The first is Reg FD, which made it unambiguously illegal to tip well-connected traders with inside information. The second is Sarbanes-Oxley, and the general “proliferation of consultants” which has both increased the number of places from which inside information can leak, and which has increased the amount of deniability that any leaker enjoys. Finally, there’s the fact that companies “have a much better real-time sense of how they are doing”, these days, which increases the amount of time that information has to remain secret before it is made public in quarterly earnings reports.

Surowiecki has a potential solution to these problems:

In a world where companies increasingly know about their business in real time, it makes no sense that public reporting mostly follows the old quarterly schedule. Companies sit on vital information until reporting day, at which point the market goes crazy. Because investors are kept in the dark, the value of inside information is artificially inflated… More consistent, if not real-time, data about revenue, new orders, and major investments would help investors make more informed decisions and, into the bargain, would diminish the value of insider information.

This makes a certain amount of sense to me. Indeed, it wouldn’t surprise me to learn that Google, or Amazon, could quite easily provide daily rather than quarterly financial statements, with the quarterly statements basically just being a reprise of information the company had already made public over the course of the quarter. Doing so would be quite Googley, actually.

But there are two reasons why most companies would never go down such a road. The first is just that they’re not technically capable of doing so. And the second is that most companies reflexively seek to keep control of their financial information. Reg FD has stopped them from picking and choosing who gets the information, but they can at least control what information they disclose, and when. Most of the time, they err on the side of disclosing less rather than more, since information is power and the company wants to keep power for itself rather than make it public.

In fact, companies don’t really care whether there’s insider trading going on in their stock. Indeed, as Surowiecki says, in the days before Reg FD they would actively encourage such trading, by dropping tidbits of information into favored analysts’ laps. So long as the information is going to come out anyway, the company should try to curry some favors from it somehow.

The point is that insider trading is a pretty victimless crime: the main damage it does is just to trust in the level playing field of the stock market, and that trust has been damaged much more greatly by various high-frequency algobots than it has by insider traders. If you’re a buy-and-hold investor, you won’t be hurt by insider trading; if anything, the broad knowledge of its existence will just make stocks that much cheaper for you to buy.

So why go to such great lengths to try to stamp it out? The SEC seems to be concentrating on insider-trading prosecutions almost to the exclusion of everything else, and it would cost corporate America billions of dollars to move to Surowiecki’s world of continuous data dissemination. I do understand that we should prosecute things which are illegal, and that there’s something deeply unfair about people making money from insider trading. But let’s not lose sight of the big picture. We’re already spending too much money and effort fighting insider trading, and, as Surowiecki shows, it’s a fight we’re losing anyway. My guess is we’d be better off if the SEC trained its considerable resources on fraud and real abuses of small investors, in the knowledge that there might be a bit more insider trading at the margin. It wouldn’t be an ideal world, but I think there would be more real benefits for the cost expended.

Comments
17 comments so far

“If you’re a buy-and-hold investor, you won’t be hurt by insider trading”

and of course, if you’re a buy-and-hold investor, you won’t be hurt by “high-frequency algobots”

ps: this: “The point is that insider trading is a pretty victimless crime” is the kind of statement that deserves to get flamed and probably will… but I’ve got better things to do right now (Bruins-Pens)…

Posted by KidDynamite | Report as abusive

Kid, you’re going to have to expand on that comment after the game. If insider and hi frequency trading just affect transient prices, then how do they have any impact on the price over the long term?

Posted by KenG_CA | Report as abusive

Yes, I’ve actually made the case many times that retail investors are *helped*, not hurt, by high-frequency algobots.

Posted by FelixSalmon | Report as abusive

“I do understand that we should prosecute things which are illegal,….” (FS)

Except, of course, when it’s HSBC who’s caught red-handed on multiple felonies; then ‘boys will be boys’ is ‘The Salmon Solution’, meaning – no one should be prosecuted for anything, including homicide. Hypocrite.

Posted by MrRFox | Report as abusive

1. Consider the case of a government official granting expedited permits for a project in exchange for a bribe. That’s a victimless crime too, assuming the project would be approved anyway, albeit slower. Should we allow politicians to take bribes as well, by not prosecuting such cases?

It’s quite the opposite of a victimless crime… everyone is victimized when they see people enriching themselves due to their position of power or access to information. It makes people not want to compete or participate in capitalist society, as the game even more unfair than it already is. Not only that, every dollar of insider profit is someone else’s loss or missed profit. Just because it’s impossible to identify the exact victims doesn’t make it victimless.

2. You are right that Amazon and Google are technically incapable of producing daily financial statements. A lot goes into financial statements, you don’t just press a button.

3. If prosecuting insider trading is profitable, we should just increase the SEC budget. There’s a capitalist idea. That could fund the fraud and abuses you talk about, which would lower the cost of capital and raise economic growth.

Posted by reutersrdr9 | Report as abusive

1. Consider the case of a government official granting expedited permits for a project in exchange for a bribe. That’s a victimless crime too, assuming the project would be approved anyway, albeit slower. Should we allow politicians to take bribes as well, by not prosecuting such cases?

It’s quite the opposite of a victimless crime… everyone is victimized when they see people enriching themselves due to their position of power or access to information. It makes people not want to compete or participate in capitalist society, as the game even more unfair than it already is. Not only that, every dollar of insider profit is someone else’s loss or missed profit. Just because it’s impossible to identify the exact victims doesn’t make it victimless.

2. You are right that Amazon and Google are technically incapable of producing daily financial statements. A lot goes into financial statements, you don’t just press a button.

3. If prosecuting insider trading is profitable, we should just increase the SEC budget. There’s a capitalist idea. That could fund the fraud and abuses you talk about, which would lower the cost of capital and raise economic growth.

Posted by reutersrdr9 | Report as abusive

Insider trading and HFT are at the opposite extremes. Insider trading is a way to make an occasional killing in the market. HFT is a way to extract a small but consistent profit.

Buy-and-hold investors are far more vulnerable to the occasional killings than they are to small taxes that apply only when they trade. If you pay 10% too much, or get 10% too little, that wipes out a year of gains.

Posted by TFF | Report as abusive

As someone who has actually been convicted of insider trading (in Canada and the US) for engaging in the practice in over 100 deals spanning near 15 years, I can tell you that it is not, in my opinion, anymore common than it was in the past.

While I now know what I could have done differently to avoid getting caught let alone convicted (while still “benefiting” from the activity as long as I wanted), most engaged in the practice do not and, as a result, are being identified by advances in technology.

From my experience, “one off” inside traders try to take advantage of their informational edge by purchasing options (and that is what regulators are finally focusing upon). Inside traders, like myself, that had access to a steady stream of reliable information purchase stock and usually spread out over time and in between camouflage trades. Hedge funds were the best suited for such activity (as I told regulators) when I engaged in it and they still are. The only difference is that they are finally being identified.

When you can literally “print” or pass along money (or success in an industry) by utilizing information while rationalizing it as a victimless crime, it is a very difficult temptation to resist (and one that you would be very surprised to learn is given into quite frequently by those you — but not me — would least suspect).

S.J. Grmovsek
@insidertrading_

Posted by insidertrading | Report as abusive

On the last point about the SEC’s use of resources – with recent reductions in funding levels to the SEC (which I understand to be a House Republican strategy to undermine Dodd-Frank and “government regulation” in general), large insider trading settlements could actually be a net gain to the resources of the SEC. I haven’t looked at any numbers comparing cost of prosecution to settlements received, but in a world of $600mm insider trading settlements, it’s plausible.

Posted by dangercatz | Report as abusive

“If you’re a buy-and-hold investor, you won’t be hurt by insider trading; if anything, the broad knowledge of its existence will just make stocks that much cheaper for you to buy.”

I’m pretty sure you are familiar with the concept of adverse selection costs.

Posted by Th.M | Report as abusive

A company in the midst of a buy-back program should be allowed to time its purchases on the basis of inside information. If “the information is going to come out anyway, the company should try to” recoup some of that value for the long-term shareholders (and other stakeholders) somehow.

Posted by dWj | Report as abusive

As in many aspects of financial markets, there is ample opportunity in HFT and inside trading to exploit and damage modern marketplaces (and wallets). Information asymmetry in insider trading makes it profitable for insiders to profit from exclusive knowledge. There would definitely be a “market” for insider information, with the rewards going to the highest bidder. As long as such as situation were in existence, money would flood to the most exploitive asset manager, to the detriment of other actors in the market. Of course that information does belong to the shareholders, who, by not having it, might exit or enter a position at the wrong time and price. So there is a potential detrimental opportunity cost.

And of course HFT provides incentive to flood the media with “little rumors” in the market, exploiting multiple price changes that happen in the blink of an eye. Having an advantage of just a penny, or even a fraction thereof, per share would provide opportunity to reap untold millions (as has always been the case, but with HFT even more so).

The illegality of the drug trade in effect provides incentive to profit, but that doesn’t make the marketing of these products any less dangerous or immoral. While insider trading might not rise to that level, it is nonetheless not victimless.

Posted by KingBurough | Report as abusive

two points: 1) Here is an easy and effective way to stop most insider trading: 15 days before the end of a company’s fiscal quarter, continuing until the day after the company reports their financial quarterly results (approximately 30-45 days in total) tax any profitable trade, one opened and closed in that window of right before the quarter closes and until the company reports, at 100%. That would virtually eliminate 90% of insider trading. It would also eliminate day trading at the end of a quarter, but a small price to pay in my opinion. If you wanted to eliminate 100% just extend the time period another 30 days. 2) The author’s comment that we are spending to much money I do not believe is accurate, in the sense that I have read elsewhere that the fines and penalties that the SEC and the SDNY have collected from insider trading convictions have far exceeded the cost in manpower. That was before the $600 million the SEC received from SAC recently. It seems like a profit center to me.

Posted by dkato | Report as abusive

“insider trading is a pretty victimless crime”

That doesn’t make any sense. If an insider has knowledge of an adverse shock to the company, and passes his stock at it’s still-high price to a sucker, that sucker is going to take real losses. Meanwhile, if an insider has knowledge of positive information, and buys up stock at a low price, he’s denying the sellers an opportunity to profit; probably less-bad than the other case, but still definitely not “victimless”.

Posted by Auros | Report as abusive

Dr9 “If prosecuting insider trading is profitable, we should just increase the SEC budget. There’s a capitalist idea.”

Sorry, but that makes no sense. If prosecuting insider trading is profitable, why does it even need a “budget” funded by taxation or borrowing from the Chinese?

Spin off the function of prosecuting insider trading into a quasi-public agency, sort of like the USPS, which supports itself through selling stamps. Let the new prosecutorial body support itself with its “profitable” activity. Reduce the budget of the SEC — the agency that continues to do everything ELSE the SEC has been doing — accordingly.

Posted by Christofurio | Report as abusive

People posting about the evils of insider trading I think are not considering the outcome: stock prices move closer to their fair price more quickly. That’s really only a good and more fair thing.

Sure, during that time, insiders are making money off their trades. But since the price is wrong, half of all market participants are losing unfairly! Anyone buying a stock that is about to bomb is a sucker about to lose a lot of money, whether they buy it from an insider trader or another sucker. And the insiders don’t force anyone to trade; anyone trading with them is doing it of their own free will.

The contribution of the insider trading is that insider shorting will cause the price to drop in advance of the public announcement, meaning that the suckers who are buying before then will pay a little less and ultimately lose a little less than they would have otherwise.

Posted by jvm | Report as abusive

The sec is hunting tall poppies(Martha Stewart, Steve Cohen) because it looks good and plays well for obama.

As you have written they could do a lot for the American economy by cracking down on extortion otherwise known as patent trolling.

This would be efficient use of taxpayer funds so will never happen in America.

Posted by nzl-kz7 | Report as abusive
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