With the government pursuing a securities fraud case against Steve Cohen’s SAC Capital—though not, strikingly, against its founder and sole owner personally—the contrarians are coming out of the woodwork. From Time.com to Wonkblog, people are asking: Why ban insider trading in the first place? The great wheel of conventional wisdom appears to have turned, leaving Slate to state the obvious: The ban on insider trading does no harm, repealing it would solve nothing, and legalization could exacerbate the most dysfunctional tendencies in corporate America.
Lets start with what the would-be legalizers get right: The official rationale for the ban on insider trading makes no real sense. The pretense is that the ban helps create a level playing field, where the little guy can get a fair shake. This is nuts, because real traders and investment managers have millions of dollars to spend on research and analytics—the playing field can be as level as you like and you’re still going to get your ass kicked. Even perfect enforcement of Major League Baseball’s ban on performance-enhancing drugs isn’t going to help you strike out Alex Rodriguez. Under any rule set, only a crazy person would gamble on his ability to beat professional athletes at their own game.
The legalizers are right to bring this core truth to light. All across America, millions of people are wasting their money by going head to head against professional investors, and they should be encouraged to stop. You are not going to be able to pick stocks in a way that consistently outperforms the market average. The manager of your mutual fund isn’t either. Nor is your stockbroker. What’s more, anyone who could consistently beat the market would charge royally for his services and eat up your profits. And of course, you will not do a better job of picking a fund manager than you would do picking stocks in the first place. You, personally, should sit blissfully unaware of any information—whether insider or publicly available—and put your money in some nice low-fee index funds. Don’t trade. Don’t worry about insider trading.
And certainly don’t assume that legal action will somehow create a safer stock market for the small investor, or help middle-class retail investors get smarter about portfolio management. Legalizing insider trading will only open the door to new waves of rip-offs, as people get lured into funds purporting to offer access to insider information.
Legalized insider trading will also create huge management problems. As Jie Hue and Thomas Noe wrote in their analysis of the pros and cons of insider trading for the Federal Reserve Bank of Atlanta, the informational value of insider trading is low in any country with a sophisticated securities analysis industry. Allowing it mainly gives investors “an incentive to substitute cheaper compensation based on insider trading for expensive salary packages designed to ensure high performance,” they write. So instead of cutting your CEO a huge check, you can let him profit from his insider information.
“At the same time,” they write, under the insider-trading system “managers have an incentive to manipulate project returns to increase risk.” In other words, instead of spending their time managing their businesses for long-term growth, executives will be thinking about the optimal strategy for buying and selling their own company’s stock. This focus on financial markets would only intensify one of the worst trends afflicting the American economy today: that corporate investment has become de-linked from corporate profits. Until recently, corporate earnings and investments in equipment and software rose in lockstep, but more recently, surging profits haven’t fueled much new business spending—which has kept the job market sluggish despite strong earnings. A key culprit seems to be excessive management focus on short-term stock price movements as executive compensation has become more linked to market performance. Shifting to a world in which managerial pay is even more about share price manipulation will make things worse and worse.
Rather than pushing to legalize insider trading, we ought to consider other areas where consumer protection rationales fall short but the public interest still calls for tighter regulation. High-frequency trading outfits that use advanced algorithms and state-of-the-art computer infrastructure to exploit millisecond-long trading opportunities are sometimes said to hurt ordinary investors. The counterargument, as with insider trading, is that no number of regulations will change the fact that small investors are saps and the trades speed up price discovery. But as with insider information, the marginal value of speedier price discovery to America’s already sophisticated financial markets is extremely low. The harm, meanwhile, is in the diversion of effort. Just as we want executives focused on growing their businesses rather than timing trades, it’s unhealthy to have too much talent and resources devoted to algorithmic trading, which is a much more zero-sum game than normal programming or traditional market research.
Securities regulation is never going to turn the stock market into a level playing field, and we shouldn’t worry about whether or not it’s succeeding. The risk of lax rules, however, is that the stock market becomes a dangerous distraction from the real business of the economy. Laws against insider trading help stop that, they ought to be enforced, and they ought to be a model for looking at further curbs on speculative activity.