14A033 Insider Trading by Jim Davies, 8/14/2014    

Last month a PBS Frontline program explored the subject of insider trading, but ended up no more than a parrot repeating the government view: that it's criminal. It even floated the opinion that the SEC and FBI might be pursuing such white-collar criminals even more aggressively than they are, and focused on Steven Cohen, owner of SAC Capital, who has been given a heap of trouble already in civil suits but not, so far, by a criminal prosecution.

Frontline played extracts from a videotaped deposition by Cohen, in which he was asked which parts of the insider trading laws he didn't understand; and in effect he replied "all of them." His point was that it's too vague for ordinary mortals to understand. Prohibited is the trading of stocks based on "non-public information" and Cohen, an expert in the field, said he could not distinguish between data that is public and that which isn't.

I don't blame him. The borderline seems fuzzy at best, and setting one is arbitrary. At first sight it appears to protect outsiders from "unfair" trading competition because insiders will generally have key information sooner than others; but what this completely misses is that stock price movements act as a signal. This is universally true; if banana prices rise, it's a signal to release more from cold storage (and eventually to grow more) even though the reason for the rise in price (and presumably demand) is completely unknown.

So if an insider buys stock, his very action is informing the rest of the market that he thinks good news is on the way. Other traders will notice the price rise and without needing any more data, will act upon it. They may be curious about the cause, and may take steps to uncover it, but meanwhile they watch the charts and make some profit. The inside trade has brought benefit to everyone affected. Perhaps the insider made more profit than most - fair enough, for his knowledge of that one circumstance was superior - but because many others quickly follow his lead, the price curve follows a gradual track. There is no dramatic change. This is particularly useful when the underlying news is bad rather than good; it means that outside traders can limit their losses, thanks to the early actions of insiders.

But Nanny says No; insiders are forbidden to give such signals. The insider trading law therefore hurts traders who do not have inside knowledge - almost everyone, in fact. The prohibition makes no sense even on its own terms (that it's "unfair" for someone to make money off non-public information) because in its nature, any one person can be an "insider" only in a single case or a very limited number of cases. For all others, he's an outsider.

Cohen's case demonstrates the high value of information; he is wealthy because he persists in uncovering business news before anyone else gets it. In talking to his network of people who know facts of value, he is probing the arbitrary borderline between what is "public" and what is not; and so is everyone else in his trade. He is better at it than most. The fact that he can uncover information that government people might call "inside" and act on it in the market merely means he is waving signals to everyone else to follow his lead, to their considerable benefit. Thus, he is a benefactor.

Insider traders are benefactors, in the classic Adam Smith sense; they are setting out to benefit only themselves (of course! Why not?) but incidentally help everyone else too, without even meaning to and, I suppose, in some cases while meaning not to. They cannot avoid helping others, because the fact of making a purchase of stock necessarily sends a public signal. Unless government prevents them, that is.

Government's prohibition therefore inhibits this beneficial conduct. It prevents plain folk making as much money as they might when a stock is set to rise, and hammers them into a much sharper loss when the opposite takes place.

Such is government, and after it has evaporated there will be no more such nonsense in the market. More wealth will be made, and it will be spread around more widely.