Insider Trading: A Legal, Ethical, or Economic Issue?

Insider trading, to simplify, is the illegal use of undisclosed material information by insiders for profit (s0me insider transactions are perfectly legal). Over the past year, several high profile cases of insider trading have come to light in the U.S., to the point that I felt I was tele-transported back to the 1980s and the era of Michael Milken, Dennis Levine, Martin Siegel and Ivan Boesky (the “Rat Pack”). Since last summer, for instance, I have been following with fascination the case of Raj Rajaratnam of the Galleon hedge fund.

When a story of insider trading like this emerges, the media largely focus on the legal and moral issues entailed. It’s illegal, it’s unethical. This focus is understandable but insider trading is at least as much, and perhaps even more, an economic issue as a legal and moral one.

How can this be an economic issue? I apologize in advance for this is going to seem a little dry and theoretical. I promise not to have too many posts in that style. Insider trading has to do with the branch of economics called microeconomics. Let me explain. The market is supposed to be a place where firms and consumers meet to trade goods and services with no governmental intervention or interference. This is an ideal. In practice, however, markets do not always lead to socially efficient outcomes and governments have to intervene to correct certain “market failures”, a term that will inflict great pain to true-blood free-marketers for whom “Markets can not fail. There are only Government failures”. But markets do fail. Often. And to correct these market failures, Governments usually intervene through an instrument called “policy” and these policies will often impact managerial and/or consumer decisions, the type of decisions that is the domain of microeconomics.

As well explained by Michael Baye in his excellent book on Managerial Economics there are 4 reasons why free markets fail to provide the socially efficient quantities of goods:

  • Market Power
  • Externalities
  • Public Goods
  • Incomplete Information

Insider trading corresponds to the fourth type of market failure: incomplete information. A key ingredient of market efficiency is the need for participants in the market place to have reliable information about price, quantity, quality, risks, etc. No one should expect to have perfect information, but information should be “reasonably reliable”. When participants have incomplete information about factors critical to any decision making, things can go wrong. Baye provides several examples where the Government has to step in to provide information to consumers (e.g., about the ingredients in some foods, the dangers of tobacco smoking or of certain drugs). Governments have to do this because suppliers “left to their own devices”  may not spontaneously provide information to consumers, particularly when such information could curtail demand for their products, and therefore hurt sales.

Insider trading is not so much a question of incomplete information as it is one of asymmetric information. For Baye, asymmetric information is “one of the more severe causes of market failure” (p. 527) and there is asymmetric information when some market participants have better information than others. Legislation against insider trading in the stock market is one of the best and classic illustrations of government intervention aimed at alleviating the market failure caused by asymmetric information. For economists the problem with insider trading is not primarily a legal or moral one. When one person (the insider) has “privileged” information about a company’s stock, its performance, its products or services, or a forthcoming innovation that will increase the enterprise value or stock value, it can “destroy the market by inducing others to stay out of it” (p. 527). The very existence of the market is at risk.

Why? The reasoning is that “outsiders” will refuse to participate in a market that is dominated by “insiders” who will only sell when they know that prices are about to fall and will only buy when they know prices are about to rise. This concern is clearly an economic one, not a legal or ethical one. Economics is concerned with the efficient functioning of markets and this is why it is concerned with insider trading. If insider trading has the potential to make the financial market less efficient or even to destroy it, economists must have reached the conclusion that this risk is sufficient ground to justify an exception to the free market principle, a deviation from this ideal but elusive objective, and to allow – indeed urge- that Governments intervene, through the adoption of a special legislation and its severe enforcement (as legislation that is not enforced is useless).

This brings us back to the Law. The risks posed to financial markets by the practice of insider trading explain why many countries, especially those with large financial markets, have enacted increasingly comprehensive and severe legislation to prohibit insider trading and why they usually enforce that legislation quite strictly.

In the U.S., the rules against insider trading are quite old: they were first introduced by the Securities and Exchange Act of 1933, a federal piece of legislation enacted as a result of the famous crash of 1929, amended in 1934, then again in 1990 and, more recently, by the Sarbanes-Oxley Act of 2007. This is the legislative “arsenal” that Mr Rajaratnam has been facing in Manhattan courts, like so many before him. Similar rules exist in most OECD countries and emerging economies with more recently established stock markets are also following the same path. For example, Brazil enacted its Law on insider trading in 2001, but the first convictions only occured in February 2011, a full 10 years later:

The big challenge in insider trading cases, in any country, is enforcement, gathering evidence and securing convictions.


Michael R. Baye (2010). Managerial Economics and Business Strategy. 7th edition. Boston: Mc Graw Hill Irwin. Chapter 14 (A Manager’s Guide to Government in the Marketplace), p. 507-537


2 thoughts on “Insider Trading: A Legal, Ethical, or Economic Issue?

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